[Federal Register Volume 60, Number 26 (Wednesday, February 8, 1995)]
[Proposed Rules]
[Pages 7468-7479]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-3076]
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DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT
Office of Federal Housing Enterprise Oversight
12 CFR Chapter XVII
RIN 2550-AA02
Risk-Based Capital
AGENCY: Office of Federal Housing Enterprise Oversight, HUD.
ACTION: Advance Notice of Proposed Rulemaking.
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SUMMARY: Title XIII of the Housing and Community Development Act of
1992, known as the Federal Housing Enterprises Financial Safety and
Soundness Act of 1992, gives the Office of Federal Housing Enterprise
Oversight (OFHEO) the responsibility for developing a risk-based
capital regulation for the Federal National Mortgage Association and
the Federal Home Loan Mortgage Corporation (collectively, the
Enterprises). To discharge this responsibility, OFHEO must develop and
implement a risk-based capital ``stress test'' that, when applied to
the Enterprises, determines the amount of capital that an Enterprise
must hold initially to maintain positive capital throughout a ten-year
period of economic stress.
This Advance Notice of Proposed Rulemaking (ANPR) announces OFHEO's
intention to develop and publish a risk-based capital regulation and
solicits public comment on a variety of issues prior to the publication
of a proposed rule. OFHEO requests comment from the public concerning
issues set forth in the ``Solicitation of Public Comment'' subsection
of the Supplementary Information section below.
DATES: Comments regarding the ANPR must be received in writing on or
before May 9, 1995.
ADDRESSES: Send written comments to Anne E. Dewey, General Counsel,
Office of General Counsel, Office of Federal Housing Enterprise
Oversight, 1700 G Street, NW, Fourth Floor, Washington, D.C. 20552.
FOR FURTHER INFORMATION CONTACT: David J. Pearl, Director, Research,
Analysis and Capital Standards; or Gary L. Norton, Deputy General
Counsel, Office of Federal Housing Enterprise Oversight, 1700 G Street,
NW, Fourth Floor, Washington, D.C. 20552, telephone (202) 414-3800 (not
a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
Title XIII of the Housing and Community Development Act of 1992,
Pub. L. No. 102-550, known as the Federal Housing Enterprises Financial
Safety and Soundness Act of 1992, 12 U.S.C. 4501 et seq. (Act),
established the Office of Federal Housing Enterprise Oversight (OFHEO)
as an independent office within the Department of Housing and Urban
Development. OFHEO's primary function is to ensure the financial safety
and soundness and the capital adequacy of the nation's two largest
housing finance institutions--the Federal National Mortgage Association
(Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie
Mac) (collectively, the Enterprises).
Fannie Mae and Freddie Mac are Government-sponsored enterprises
that serve important public purposes and receive significant financial
benefits, including exemption from state and local income taxes and
special treatment of their securities in a variety of regulatory and
transactional situations. Although the securities that they issue or
guarantee are not backed by the full faith and credit of the United
States,\1\ their status as Government-sponsored enterprises creates, in
the view of financial market participants, an implicit Federal
guarantee of those securities. Furthermore, the failure of either of
the Enterprises would have serious consequences for the performance of
the nation's housing markets, with a potentially disproportionate
effect on low- and moderate-income families.
\1\See section 306(h)(2), Federal Home Loan Mortgage Corporation
Act (12 U.S.C. 1455(h)(2)) and section 304(b), Federal National
Mortgage Association Charter Act (12 U.S.C. 1719(b)).
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The Enterprises engage in two principal businesses. First, they
maintain a portfolio of residential mortgages and, second, they issue
and guarantee pools of residential mortgages--in the form of mortgage-
backed securities (MBS)--that are held by investors. One of the
Enterprises' principal financial risks stems from losses associated
with defaults on mortgages that they hold or guarantee. The other
financial risk stems from losses associated with changes in interest
rates. Because the effective maturities of the Enterprises' assets and
liabilities are not the same, interest rate changes could cause the
margin between the average yield on assets and the average yield on
liabilities to narrow or even become negative.
The Enterprises' capital serves as a cushion to absorb financial
losses for a [[Page 7469]] period of time until the cause of the losses
can be remedied, thereby reducing the risk of failure. The Act requires
OFHEO to establish, by regulation, risk-based capital standards for the
Enterprises. The regulation will describe a risk-based capital stress
test (stress test) that OFHEO will develop and implement to determine
for each Enterprise the amount of capital\2\ necessary to absorb losses
throughout a hypothetical ten-year period marked by severely adverse
circumstances (stress period).
\2\For purposes of the ANPR, the term ``capital'' means ``total
capital'' as defined under section 1303(18) of the Act (12 U.S.C.
4502(18)) to mean the sum of the following:
(A) The core capital of the [E]nterprise;
(B) A general allowance for foreclosure losses, which--
(i) shall include an allowance for portfolio mortgage losses, an
allowance for nonreimbursable foreclosure costs on government
claims, and an allowance for liabilities reflected on the balance
sheet for the [E]nterprise for estimated foreclosure losses on
mortgage-backed securities; and
(ii) shall not include any reserves of the [E]nterprise made or
held against specific assets.
(C) Any other amounts from sources of funds available to absorb
losses incurred by the [E]nterprise, that the [Director of OFHEO] by
regulation determines are appropriate to include in determining
total capital.
The term ``core capital'' is defined under section 1303(4) of
the Act (12 U.S.C. 4502(4)) to mean the sum of the following (as
determined in accordance with generally accepted accounting
principles):
(A) The par or stated value of outstanding common stock.
(B) The par or stated value of outstanding perpetual,
noncumulative preferred stock.
(C) Paid-in capital.
(D) Retained earnings.
The core capital of an [E]nterprise shall not include any
amounts that the [E]nterprise could be required to pay, at the
option of investors, to retire capital instruments.
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Use of a stress test will enable OFHEO to tailor carefully the
Enterprises' capital standards to the specific risks of the
Enterprises' businesses. It also will provide a structure for
incorporating interrelationships among different types of risk
(prepayments, for example, relate to both credit and interest rate
risk).
Statutory Requirements
The Act specifies a risk-based capital standard for each
Enterprise. This standard establishes the amount of capital necessary
to withstand simultaneously adverse credit and interest rate risk
scenarios during the stress period plus an additional amount to cover
management and operations risk, as follows:
Credit Risk
The Act establishes a credit risk scenario based on a regional
recession involving the highest rates of default and loss severity
experienced during a period of at least two years in an area containing
at least five percent of the total U.S. population. The stress test
will apply these default and loss rates, with any appropriate
adjustments, over the ten-year stress period on a nationwide basis to
the Enterprises' books of business.\3\
\3\Section 1361(a)(1) (12 U.S.C. 4611(a)(1)).
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Interest Rate Risk
The Act presents two interest rate risk scenarios, one with rates
rising and the other with rates falling. The Act further describes the
path of the ten-year Constant Maturity Treasury (CMT) yield for each
scenario and directs OFHEO to establish the yields of other financial
instruments during the stress period in a reasonably consistent manner.
The stress test for each Enterprise incorporates the scenario with the
most adverse impact.\4\
\4\Section 1361(a)(2) (12 U.S.C. 4611(a)(2)).
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In the rising rate scenario, the ten-year CMT yield increases
during the first year of the stress period and then remains constant at
the greater of (a) 600 basis points above the average yield during the
preceding nine months or (b) 160 percent of the average yield during
the preceding three years. The Act further limits the increase in yield
to a maximum of 175 percent of the average yield over the preceding
nine months.\5\
\5\Section 1361(a)(2)(C) (12 U.S.C. 4611(a)(2)(C)).
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In the falling rate scenario, the ten-year CMT yield decreases
during the first year of the stress period and then remains constant at
the lesser of (a) 600 basis points below the average yield during the
preceding nine months or (b) 60 percent of the average yield during the
preceding three years. The Act further limits the decrease in yield to
not more than 50 percent of the average yield in the preceding nine
months.\6\
\6\Sections 1361(a)(2)(B) (12 U.S.C. 4611(a)(2)(B)).
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New Business and Other Activities and Considerations
Initially the stress test assumes that the Enterprises conduct no
additional new business once the stress period begins, except for the
fulfillment, in a manner consistent with recent experience and the
economic characteristics of the stress period, of contractual
commitments to purchase mortgages and issue securities.\7\
\7\The Act states that OFHEO may consider the impact of new
business conducted during the stress period after taking into
consideration the results of studies conducted by the Congressional
Budget Office and the Comptroller General on the advisability and
appropriate forms of new business assumptions. The studies must be
completed within the first year after the issuance of the final
risk-based capital regulation. OFHEO may incorporate new business
into the stress test four years after the regulation is issued.
Section 1361(a)(3)(C) and (D), (12 U.S.C. 4611(a)(3)(C) and (D)).
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The stress test must take into account distinctions among mortgage
product types, different loan-to-value ratios (LTVs), and any other
appropriate factors.\8\ OFHEO determines the appropriate consideration
and treatment of all other factors, activities, or characteristics of
the stress period not explicitly identified and/or treated in the Act--
such as mortgage prepayments, hedging activities, operating expenses,
dividend policies, etc.--on the basis of available information, in a
manner consistent with the stress period.\9\
\8\Sections 1361(b)(1) and (d) (12 U.S.C. 4611(b)(1) and (d)).
The Act uses the phrase ``differences in seasoning of mortgages''
which is equivalent to differences in LTVs. The term ``seasoning''
is defined as the change over time in the ratio of the unpaid
principal balance of a mortgage to the value of the property by
which such mortgage loan is secured. Section 1361(d)(1) (12 U.S.C.
4611(d)(1)).
\9\Sections 1361(b) and (d)(2) (12 U.S.C. 4611(b) and (d)(2)).
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Management and Operations Risk
Finally, to provide for management and operations risk, after
determining the amount of capital an Enterprise needs to survive the
stress test, the Act requires OFHEO to increase that amount by 30
percent to set the required risk-based capital level for each
Enterprise.\10\
\10\Section 1361(c)(2) (12 U.S.C. 4611(c)(2)).
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Philosophy Guiding Stress Test Development
The mission of OFHEO is to ensure that the Enterprises are
adequately capitalized and operating in a safe and sound manner,
consistent with the achievement of their public purposes. The principal
objective of risk-based capital standards is protection of the taxpayer
from potential Enterprise insolvency. However, effective capital
standards should also permit the Enterprises to fulfill their public
purposes while pursuing prudent business practices and strategies.
Although the stress test produces a single capital requirement, it
effectively creates marginal capital requirements--incremental
requirements for each additional dollar of business--for every type of
product the Enterprises guarantee or hold in portfolio. Marginal
capital requirements for mortgages held in portfolio will vary
depending on the risk, as reflected in the stress test, of an
Enterprise's funding strategy. These marginal capital requirements will
have significant bearing on how the Enterprises choose to conduct their
businesses.
OFHEO will seek to design the stress test so that the incentives it
creates closely reflect the relative risks inherent [[Page 7470]] in
the Enterprises' different activities. To this end, OFHEO will
incorporate, to the extent feasible, consistent relationships between
the economic environment of the stress period and the Enterprises'
businesses. This will require modeling the Enterprises' assets,
liabilities, and off-balance sheet positions at a sufficient level of
detail to capture their various risk characteristics. Taking all this
into consideration will require a balance between the complexity and
realism of the stress test and its timeliness.
Solicitation of Public Comments
OFHEO requests public comment on a number of subjects that must be
addressed in its risk-based capital regulation. OFHEO will consider the
comments received in response to this ANPR when developing a proposed
rule. Following consideration of comments on the proposed rule, OFHEO
will issue a final regulation. When addressing a specific question
contained in this ANPR, OFHEO asks that commenters specifically note by
number which question is being addressed.
I. Credit Risk
The Enterprises face similar mortgage credit risk in their
portfolio and securitization businesses. OFHEO defines mortgage credit
risk as the risk of financial loss due to borrower default and
subsequent foreclosure and liquidation of a mortgaged property. Losses
are realized when the unpaid loan balance on a defaulted mortgage
exceeds the net proceeds of a foreclosure sale, after deducting
carrying and selling costs, less any recoveries from any private
mortgage insurer, recourse agreement, or other credit enhancements.
Loans with high current LTVs, where the borrowers have little to no
equity in their homes, are the most likely to default.\11\ For any
given set of mortgage loans, the probability of default is typically
low in the first year after origination, rises to a peak somewhere
between the third and seventh year, and declines thereafter. If
declining interest rates induce prepayments on a group of mortgage
loans due to borrower refinancing activity, defaults and losses on
those mortgage loans likely will be reduced, because some of the
prepaid loans would ultimately have defaulted. However, the remaining
group of loans is likely to be at greater risk of default, because it
includes all of the original loans where the borrower would not have
qualified for refinancing, but only some of the loans where the
borrower was eligible.
\11\For example, see C. Foster and R. Van Order, ``An Option
Based Model of Mortgage Default Rick,'' Housing Finance Review,
3(4):351-372, 1984; C. Foster and R. Van Order, ``FHA Terminations:
A Prelude to Rational Mortgage Pricing,'' AREUEA Journal, 13(3):273-
291, 1985; and R.L. Cooperstein, F.S. Redburn, and H.G. Meyers,
``Modelling Mortgage Terminations in Turbulent Times,'' AREUEA
Journal, 19(4):473-494. For a review of the literature in this area,
see R.G. Quercia and M.A. Stegman, ``Residential Mortgage Default: A
Review of the Literature,'' Journal of Housing Research, 3(2):341-
379, 1992.
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Economic downturns result in more frequent and severe losses in all
categories of mortgage loans, especially in a period of house price
declines. The stress test will incorporate changes in the economic
environment and simulate the relationship of those changes to mortgage
defaults.
A. Defining a Stress Benchmark
The Act, in defining the risk-based capital stress test, refers to
two time periods--a hypothetical ten-year ``stress period'' during
which the Enterprises' capital should be sufficient to absorb losses
and maintain a positive capital level while being subjected to adverse
credit and interest rate risk scenarios, and the time period of ``not
less than two years'' for which the ``highest rates of default and
severity of mortgage losses'' occurred in a region containing at least
five percent of the total population of the United States.\12\ For the
purposes of this ANPR, OFHEO characterizes the latter time period and
region as a ``stress benchmark.'' The stress benchmark will provide the
basis for the development of the credit risk stress scenario that will
be applied during the ten-year stress period.
\12\Section 1361(a)(1) (12 U.S.C. 4611(a)(1)).
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The Act permits the identification of one or more stress
benchmarks. A single benchmark is conceptually appealing but presents a
number of difficult issues. A single benchmark may not include
sufficient data on all Enterprise product types. Patterns of
multifamily and single family mortgage losses differ (see ``Mortgage
Types'' below) and a stress benchmark for multifamily mortgages
representing the worst regional experience for those mortgages may not
coincide with the benchmark for single family mortgages based on their
worst experience. Finally, data limitations may prevent OFHEO from
determining loss severities during the period of highest default rates;
alternatively, highest loss severities may not coincide with highest
rates of default by time period or region.
Although the Act does not refer to a particular mortgage product in
its reference to ``highest rates of default and severity,'' single
family, 30-year, fixed-rate mortgages have long comprised the bulk of
Enterprise mortgages. OFHEO expects to define a stress benchmark for
these mortgages on the basis of a weighted average (by unpaid loan
balance of various LTV groups) of default rates.
Existing data on loss severities may be inadequate to contribute to
establishing the timing or location of the worst regional experience.
Systems for the storage and analysis of data on foreclosed properties
are a relatively recent development. To overcome these data
deficiencies, OFHEO will consider a number of approaches to determining
loss severity rates during the stress benchmark. These approaches
include the use of loss severity estimates obtained from different
sources and for different time periods and regions than those used to
estimate the benchmark default rates.
OFHEO may use models (see ``Models of Default and Prepayment'' and
``Models of Loss Severity'' below) to establish aspects of the
benchmark for which data are insufficient or unavailable. These might
include, in addition to loss severities for all products, default rates
for mortgage products poorly represented or non-existent in the stress
benchmark. Econometric models for default, mortgage prepayment, and
loss severity would facilitate consideration of the simultaneous impact
of many factors on default rates, such as changes in LTVs, the impact
of contemporaneous prepayments, and the impact of factors associated
with mortgage product types. Models would provide a link between the
performance of mortgages owned or guaranteed by the Enterprises during
the stress period and performance during the stress benchmark, with due
consideration of the economic circumstances of the stress period, e.g.,
interest rates and house prices.
Data Issues
OFHEO has received access to detailed information about the loss
experience on mortgages that the Enterprises owned or guaranteed from
the mid-1970s through the present. The type of information on mortgages
that OFHEO needs to develop the stress test includes date of
origination, original LTV ratio, type of mortgage, location, nature and
degree of any credit enhancements, date of last paid installment,
termination type, e.g., default or prepayment, and the amount of any
ultimate loss (including holding and selling costs). However, there are
serious gaps in the data on loss severity through the early 1980s
resulting from the lack of systems for the storage and
[[Page 7471]] analysis of data on foreclosed properties and the manner
in which loan balances were reported by seller/servicers.
In general, however, with the increase over time of the
Enterprises' share of the overall mortgage market, the data grow
increasingly rich. If necessary, OFHEO could supplement these data with
data from the Federal Housing Administration or other sources such as
TRW Redi and Mortgage Information Corporation.
If the stress benchmark is wholly or primarily based on Enterprise
data, the loan-level data could be aggregated across the two
Enterprises in order to determine the worst historical experience.
Preliminary analysis suggests that the worst historical experience may
be different for the two Enterprises. An alternative would be to
determine the worst historical experience for each Enterprise
separately and then use a simple or weighted average of default rates.
Question 1: What data and methodology should OFHEO use in its
determination of the stress benchmark?
Benchmark Time Period and Region
OFHEO has considered at least two approaches for defining the
benchmark time period. It could be defined as the period in which the
highest rates of default occurred, that is, an ``exposure year''
approach; or the period in which the loans with the highest cumulative
or lifetime rates of default were originated, which can be termed an
``origination year'' approach. At the start of the stress period, the
Enterprises' books of business will include survivors from many loan
origination years. An exposure year benchmark corresponds more closely
to the manner in which the Enterprises' mortgage portfolios will
experience the risk of credit losses as they move through the ten-year
stress period. However, using exposure years may complicate adjustments
for differences in LTVs and other factors (see ``Relating Stress Period
Default Rates to Benchmark Default Rates'' below). Using origination
years may require some adjustment for differences in mortgage age (see
``Mortgage Age'' below) since virtually all of the Enterprise mortgages
will have been originated prior to the start of the stress period.
Alternative approaches to defining the stress benchmark (exposure
year versus origination year) suggest alternative analyses of defaults.
An exposure year approach requires the determination of default rates
on loans of varying age at risk of failure within a specified period.
The resulting time-period specific default rates for loans outstanding
at the beginning of the period can be termed ``conditional rates.''
Because default rates vary with the age of a mortgage (see ``Mortgage
Age'' below), OFHEO might define an age schedule of conditional default
rates for loans outstanding at the start of the stress benchmark.\13\
For comparison across time periods and regions, synthetic cumulative
default rates for the stress benchmark could be derived under a common
set of prepayment assumptions. In an origination year approach, either
cumulative or conditional default rates could be used.
\13\Age is often a proxy for additional unobserved factors
affecting the default probabilities of individual mortgages.
Immediately after origination, default is unlikely for all
borrowers. Default rates first rise over time as new information
about properties and borrowers is revealed. Then as relatively
weaker borrowers default, the average rate of default declines. See,
for example, the discussion in C. Pestre, P. Richardson, and C.
Webster, ``The Lehman Brothers Mortgage Default Model and Credit-
Adjusted Spread Framework,'' Mortgage Market Analysis, Lehman
Brothers, Fixed Income Research, January 28, 1992. Other influential
default studies that have included mortgage age as an explanatory
factor include: T. Campbell and J. Dietrich, ``The Determinants of
Default on Conventional Residential Mortgages,'' Journal of Finance,
38(5):1569-1581, 1983; D. Cunningham and C. Capone, ``The Relative
Termination Experience of Adjustable to Fixed-Rate Mortgages,'' The
Journal of Finance, 45(5):1687-1703, 1990; and J.M. Quigley and R.
Van Order, ``More on the Efficiency of the Market for Single Family
Homes: Default,'' Center for Real Estate and Urban Economics,
University of California, Berkeley, 1992.
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The Act requires that the benchmark region comprise a contiguous
area containing at least five percent of the total United States
population. Part or all of states such as Texas or California satisfy
this population requirement; however, areas experiencing the highest
rates of default may cross over one of these state's boundaries into
adjoining states. As appropriate, OFHEO will use a definition of
benchmark region that includes more than one state, part of one state,
or parts of several states.
Question 2: How should the benchmark time period be defined?
Measurement of Default
Default can be defined in several ways: Defaults can be deemed to
occur at the time a borrower ceases making payments, when a loan
payment is past due by a contractually specified number of days, on the
date of foreclosure, or on the date when losses are recognized.
Defaults can be measured on a gross basis or net of any subsequent
cures.
Question 3: What are the relative merits of the alternative
approaches for the measurement of mortgage defaults?
B. Relating Stress Period Default Rates to Benchmark Default Rates
Default rates during the stress period may differ from the default
rates associated with the stress benchmark. This difference may result
from differences between the characteristics and composition of an
Enterprise's mortgages at the start of the stress period relative to
those of the mortgages identified with the stress benchmark. Stress
period default rates may also differ from stress benchmark rates as a
result of differences in the stress period environment, such as
interest rates and inflation. OFHEO must also specify the timing of
defaults and losses during the stress period.
The Act requires that OFHEO, in establishing the stress test, take
into account appropriate distinctions among types of mortgage products,
differences in LTVs, and other factors that OFHEO's Director considers
appropriate.\14\ Such factors include prepayment activity, mortgage
age, and loan size. The Act also requires an adjustment for the effects
of general inflation in the highest interest rate environment in the
stress test.\15\
\14\Section 1361(b)(1) (12 U.S.C. 4611(b)(1)).
\15\Section 1361(a)(2)(E) (12 U.S.C. 4611(a)(2)(E)).
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Loan-to-Value Ratios
The payment of principal and changes in the value of the property
securing a mortgage affect LTVs over time. Repayments of loan principal
and rising property values lower LTVs, while falling property values
raise LTVs. Because LTV is a common measure of borrower equity, and
borrower equity is a major factor determining defaults and losses, the
stress test must take into account changes in LTVs. If distributions of
LTVs during the stress period differ from those for the same types of
loans associated with the stress benchmark, defaults and losses during
the stress period will likely differ from those of the benchmark.
All loans owned or guaranteed by the Enterprises at the start of
the stress period will have been originated prior to that time.
Although relatively good estimates of property value are available at
the time of loan origination, OFHEO will need to use house price
indexes to obtain estimates of the LTVs for mortgages at the start of,
and possibly throughout, the stress period.\16\ OFHEO
[[Page 7472]] intends to use a repeat sales index based on sales (or
appraisals undertaken by borrowers in conjunction with refinancing the
mortgages) of the Enterprises' owned and guaranteed portfolios (see
``House Price Indexes'' below).
\16\For an origination year benchmark, OFHEO will likely have
access to accurate information about the original LTVs for all
benchmark loans. On the other hand, to develop an exposure year
benchmark, OFHEO will have to estimate LTVs during the benchmark
time period for all loans originated earlier. OFHEO would use house
price indexes for this purpose.
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Models of mortgage default and prepayment (see ``Models of Default
and Prepayment'' below) emphasize the importance of LTV because of its
direct relationship to homeowner's equity, defined as the difference
between the value of a property and the outstanding principal balance
of the related mortgage. These models differ in their treatment of
house price changes and with regard to how changes in equity affect
default and prepayment. For example, one approach assumes that defaults
occur only among loans with negative equity.\17\ House price indexes
only provide estimates of the average change in property values between
two dates. Because changes in individual property values are not
continuously observed, simulation models have been used to characterize
the distribution of changes in house prices relative to the market
average. Estimates of the percentage of loans with negative equity and
estimates of default rates can be derived from these distributions.
\17\See Foster and Van Order, supra, (1984, 1985).
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This approach assumes that homeowner's equity includes not just the
difference between property value and outstanding loan amount, but also
the current value of the mortgage to the borrower. A below-market rate
loan has positive value. The precise value of the mortgage depends on
the loan interest rate relative to the current market rate and the
borrower's expectations about future interest rates and mobility. A
borrower whose loan has a fixed contract rate below current market
yields has more to lose by defaulting than a borrower with a note rate
above the current market rate.
Question 4: What is the appropriate way in which to adjust the LTVs
of mortgages in the stress test?
Question 5: If estimates of the distribution of house price changes
are used to adjust the LTVs of mortgages, what is an appropriate
method, e.g., stochastic process?
Question 6: In what manner, if at all, should OFHEO incorporate
mortgage value as a factor affecting defaults?
Mortgage Types
Single Family
The Act requires that the stress test consider differences in
mortgage types (single family or multifamily, fixed or adjustable rate,
first or second lien, owner-occupied or investor owned, positive or
negative amortization, alternate term to maturity, etc.).\18\ Risk
characteristics of different types of mortgages vary considerably.
Because of the fundamental differences between single family and
multifamily mortgage risk, we discuss the latter in a separate section
below.
\18\Sections 1361(b)(1) and (d)(2) (12 U.S.C. 4611(b)(1) and
(d)(2)).
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Given that OFHEO plans to establish the stress benchmark based on
single family, 30-year, fixed-rate mortgages, the Act calls for OFHEO
to identify the worst rates of default and losses for any time period
or region.\19\ The Enterprises may not have held certain types of
single family mortgages in the stress benchmark OFHEO identifies. Other
types of single family mortgages held during the stress benchmark may
have experienced their worst defaults and losses at other times or in
other regions.
\19\Section 1361(a)(1) (12 U.S.C. 4611(a)(1)).
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Alternative approaches could include use of multivariate models to
estimate separate equations for different mortgage products or
different mortgage features, default rates representing some multiple
of the standard single family mortgage, or some combination of these
approaches (see ``Models of Default and Prepayment'' below).
Question 7: How should OFHEO relate other types of mortgages to a
single stress benchmark developed based on single family, 30-year,
fixed-rate mortgages?
Multifamily
While single family properties are both a source of shelter and,
for most families, their most valuable financial asset, multifamily
properties are primarily income-producing businesses for their owners.
Multifamily loans are less homogeneous and subject to a more diverse
set of risks than single family loans. The multifamily market has more
pronounced business cycles and is heavily affected by tax and
regulatory policy. Patterns of losses over time for multifamily loans
have not tracked those of the single family market. The Enterprises
operate several different types of multifamily programs, some of which
rely heavily on lender recourse or other forms of credit enhancement
with differing risk characteristics.
Data needs in analyzing multifamily loans are greater than for
single family loans and yet the quality of such data is poorer. Data
are incomplete and cover a smaller portion of the multifamily market
than the single family market. There is also a dearth of research on
critical multifamily credit risk issues.
For the owner of a multifamily property, net operating income (NOI)
plays a more important role than equity in the decision to default. A
property's debt service coverage, rather than LTV ratio, may be the
most important indicator of multifamily credit risk, yet available data
can only provide a short time-series for income. Multifamily value
indexes are problematic because there are fewer transactions than in
the single family market and property appraisals are less reliable.
Appraisals are less reliable due to the varying methodologies used to
calculate multifamily property income and the application of so-called
``capitalization rates'' to NOI.\20\
\20\Government Accounting Office, ``Federal Home Loan Mortgage
Corporation: Abuses in Multifamily Program Increase Exposure to
Financial Losses'' (Oct. 1991); J.M. Abraham, ``On the Use of a Cash
Flow Time-Series to Measure Property Performance,'' forthcoming in
Journal of Real Estate Research; and J.M. Abraham, ``Credit Risk in
Commercial Real Estate Lending, ``Federal Home Loan Mortgage
Corporation, 1994 presented at the 1994 meetings of the American
Real Estate and Urban Economics Association (available from OFHEO).
---------------------------------------------------------------------------
Prepayments play a far less significant role in the analysis of
multifamily credit risk than single family credit risk because
``lockouts'' and yield maintenance agreements effectively prevent most
multifamily borrowers from refinancing to take advantage of declining
interest rates. The Enterprises' activity in the multifamily market is
expected to increase significantly in future years in order to meet the
affordable housing goals established under the Act.\21\ Thus, the
treatment of multifamily risks will be increasingly important.
\21\Sections 1331-1336 (12 U.S.C. 4561-4566).
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Question 8: How should existing and emerging multifamily data
sources be identified?
Question 9: What are alternative empirical and theoretical
approaches to the estimation of multifamily credit risk?
Question 10: How should the projection of defaults and losses on
the Enterprises' multifamily portfolio be related to a single family
stress benchmark?
General Price Inflation
The Act requires that OFHEO adjust credit losses in the stress test
when large increases in interest rates imply higher rates of general
price inflation.\22\ If the ten-year CMT yield is assumed to increase
by more than 50 percent over the average yield during the preceding
[[Page 7473]] nine months, inflation is presumed to be
``correspondingly higher.'' If, for example, the ten-year CMT yield
were to have averaged eight percent during the past nine months, a 50
percent increase would raise it to 12 percent. The Act, however, would
permit an increase to 14 percent.
\22\Section 1361(a)(2)(E) (12 U.S.C. 4611(a)(2)(E)).
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OFHEO would first determine what annual percentage difference in
general inflation rates best corresponds to the difference between a 12
percent and a 14 percent ten-year CMT yield over a nine-year period.
The difference in inflation rates could be assumed to be equal to the
difference in interest rates or it could be based on an estimated
historical relationship.
OFHEO would then translate that higher inflation rate into
individual house price changes. Again, the differences in house price
changes could be assumed to be equal to the difference in general price
inflation rates or could be based on an estimated relationship.
As the last step, OFHEO would translate the difference in house
price changes into differences in defaults. This could be done in the
context of a multivariate default and prepayment model used for making
many adjustments simultaneously (see ``Models of Default and
Prepayment'' below), or it could be the subject of a separate analysis.
Question 11: Should OFHEO assume a ``one-to-one'' relationship
between long-term differences in interest rates, general price
inflation rates, and house price inflation rates or should it estimate
more complex, but potentially more realistic, relationships between
these phenomena?
Question 12: What is the best method of modeling the effects of
higher house prices on defaults?
Mortgage Prepayments--Credit Risk
Prepayments are a significant factor in interest rate risk, but
they also affect credit losses. Interest rate changes have a
significant influence on mortgage prepayments. Prepayment rates are
sensitive to the differences between current market yields and the
levels of mortgage rates among outstanding mortgages. A homeowner today
will refinance (and prepay) when current mortgage rates fall as little
as 50 basis points below the rate on his or her mortgage.
Prepayment rates also depend on the time paths of interest rates.
Homeowners who fail to refinance once mortgage rates become
advantageous are relatively unlikely to do so in the future (many may
not qualify for refinancing). Thus, prepayment rates for mortgages with
a given coupon rate rise as interest rates fall below a particular
threshold, but they eventually will slow, even if interest rates remain
at the new lower levels or continue to decline. This phenomenon is
commonly known as ``burn-out.''
The expected pattern of prepayments in the stress period might be
quite different from the pattern experienced during the benchmark
period. The drastic yield curve shifts that will be experienced during
the initial year of the stress period will almost certainly not be
found during the benchmark period that OFHEO must identify. The greater
number of mortgages that prepay, the fewer are the candidates for
subsequent default. Conversely, the fewer mortgages that prepay, the
greater the number remaining that might default. At the same time, the
default risk of mortgages remaining after a refinancing wave may be
higher than previously. Many homeowners who did not take advantage of
attractive refinancing opportunities may have been unable to do so
because of higher risk profiles. Given the widely divergent interest
rate movements that the Enterprises may experience during the stress
period, loss adjustments for differing prepayment behavior could be
considerable.
If OFHEO expresses mortgage default rates as conditional rates,
defaults during any given time interval of the stress period will
depend on the proportion of mortgages outstanding at the beginning of
that time interval. Such an approach would, in effect, make a
substantial adjustment for prepayments. A more complicated adjustment
would take into account the generally higher quality of loans eligible
for refinancing. In a stress scenario involving falling interest rates,
for example, the stress test might take into account the generally
higher quality of loans that qualify for refinancing and the
potentially lower quality of surviving loans (see ``Models of Default
and Prepayment'' below). Alternatively, if the stress test involves no
interaction of the total amount of defaults and prepayments, OFHEO
still might adjust the timing of defaults during the stress period to
be consistent with prepayments expected in a particular interest rate
scenario. Mortgage prepayments are discussed further under ``Interest
Rate Risk'' below.
Question 13: Should anticipated prepayments affect the volume or
timing of defaults in the stress period?
Mortgage Age
Holding homeowner's equity constant, a number of factors make the
likelihood of borrower default vary over the life of a loan. On one
hand, changes in a borrower's circumstances subsequent to the loan's
origination, such as unemployment, marriage, divorce, childbearing,
mortality, and residential mobility, affect the likelihood of default
and prepayment, and the cumulative frequency of such events increases
as a loan ages. On the other hand, a record of consistent payments by a
borrower over time increases the probability of continued loan
performance.
Models that have included variables for both homeowner's equity and
mortgage age have found the contribution of age to be statistically
significant.\23\ This may be particularly important if an origination
year approach is used in the benchmark. Using an origination year
approach, loans in the stress benchmark would all be newly originated
loans, while those at the beginning of the stress period would be a
mixture of old and new loans.
\23\For example, see the papers cited in footnote 11 above.
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Question 14: Is it appropriate for OFHEO to factor mortgage age
into the stress test, and, if so, what is the best method of doing so?
C. Models of Default and Prepayment
There are a number of approaches to relating the factors discussed
above, such as LTV, mortgage type, mortgage age, and prepayments, to
the performance of the Enterprises during the stress period. A
comprehensive way to incorporate all of these factors into the stress
test would be to estimate joint multivariate models of default and
prepayment.\24\ A joint model of default and prepayment would ensure
the consistency of these key variables and reflect an appropriate time
pattern of defaults as well. Researchers have estimated a number of
such models.\25\
\24\Due to the unique difficulties of modeling multifamily
default and prepayment, multifamily and single-family loans would
probably need to be modeled separately. The modeling of loss
severity is discussed in the next section.
\25\Multinomial logit models for default have been estimated by
Campbell and Dietrich (1983) supra; P. Zorn and M. Lea, ``Mortgage
Borrower Repayment Behavior: A Microeconomic Analysis with Canadian
Adjustable Rate Mortgage Data, AREUEA Journal, 17(1):188-136, 1989;
and Cunningham and Capone (1990) supra. More recently, proportional
hazards models have been used to analyze default and prepayment.
See, for example, J. Quigley, ``Interest Rate Variations, Mortgage
Prepayments and Household Mobility, Review of Economics and
Statistics, 119(4):636-643, 1987; and J.M. Quigley and R. Van Order,
``More on the Efficiency of the Market for Single Family Homes:
Default,'' Center for Real Estate and Urban Economics, University of
California, Berkeley, 1992. [[Page 7474]]
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A joint approach to default and prepayment would generate default
rates reasonably related to the stress benchmark, while simultaneously
generating prepayment rates that are consistent with the interest rate
characteristics of the ten-year stress period. To estimate a
multivariate default/prepayment model, OFHEO could draw on all relevant
historical data, not just data from the stress benchmark. The model
might include explanatory variables such as LTVs at origination,
current LTVs (determined through the application of an appropriate
house price index), differences between actual mortgage coupons and
current market rates, interest rate paths, mortgage age, dummy
variables for time period and location of mortgaged property, and
additional characteristics specific to different mortgage products. The
estimation procedure could allow for changing coefficients over time to
reflect structural changes in prepayment and default behavior. During
the stress period, explanatory or dummy variables, reflecting the
special circumstances of the stress benchmark, would be set at their
benchmark levels.
While multivariate models allow for the most realistic estimates of
defaults and prepayments, OFHEO recognizes the difficulties of such an
approach. Insufficient data may complicate model selection and the
estimation of some individual parameters. One of the most simple
approaches would be to measure cumulative defaults in the stress
benchmark for the most common 30-year, fixed-rate, 80 percent LTV
mortgages and then spread those defaults evenly or according to some
predetermined pattern over the ten-year stress period, with no
consideration of prepayments. Losses on other mortgage types and LTVs
could be set at simple multiples of the ``standard'' loss rate based on
average historical experience. All other possible variables might be
ignored.
Many approaches of intermediate complexity exist. For example,
OFHEO could determine the stress benchmark default rates for standard
30-year, fixed-rate, single family mortgages for several LTV categories
and a few other types of mortgages. Relative defaults on additional
mortgage types would be determined from more recent data using
multivariate models, which would also provide adjustment factors for
some mortgage features and other relevant variables. Prepayments could
be modeled separately, affecting projected defaults by changing the
volume of surviving loans (See ``Mortgage Prepayments--Interest Rate
Risk'' below). The time patterns of defaults could also be modeled
separately as a function of mortgage age.
Question 15: What are the relative merits of using a joint model of
default and prepayment in the stress test?
Question 16: What is an appropriate statistical method for
estimating a joint model of default and prepayment?
Question 17: Should defaults be expressed in terms of conditional
failure rates (hazards), cumulative default rates, or in some other
manner?
Question 18: What explanatory variables should be included in a
statistical model for default and prepayment?
Question 19: What is an appropriate level of statistical
aggregation for the estimation of a joint model of default and
prepayment?
Question 20: How should the impact of house price trends, interest
rates, and other economic factors be incorporated into a model of
default and prepayment?
D. Models of Loss Severity
Due to the varying quality of data on losses on defaulting loans,
OFHEO may be unable to establish actual loss severities for the stress
benchmark. Even if loss severities are incorporated in the stress
benchmark, OFHEO may make adjustments to reflect changes in factors
that affect loss severities. Consequently, OFHEO will conduct a
separate analysis of loss severity based on all available data. This
section examines some of the issues involved in modeling loss severity,
including approaches for linking loss severity rates to the stress
benchmark.
Loss severity refers to the actual dollars lost on a defaulted loan
and allows credit risk to be quantified in dollar terms. Severity is
the extent to which the costs associated with default, foreclosure, and
disposition exceed the revenues associated with these processes. The
major costs are the loss of loan principal, transaction costs at both
foreclosure and disposition, and carrying costs throughout the process.
The major revenues are foreclosure sale price and mortgage insurance
payments.
Loss severity, like default, depends on numerous factors. Some
factors--original LTV ratio, LTV ratio at time of default, original
loan size, occupancy status, type of structure, and presence or absence
of mortgage insurance--are the factors that also influence the
likelihood of default. Other factors--methods of disposition, state
foreclosure laws, and home price movements after default--influence
severity without affecting the likelihood of default.\26\
\26\See, for example, T. Clauretie and T.N. Herzog, ``How State
Laws Affect Foreclosure Costs,'' Secondary Mortgage Markets,
6(Spring):25-28, 1989; T. Clauretie and T.N. Herzog, ``The Effect of
State Foreclosure Laws on Loan Losses: Evidence from the Mortgage
Insurance Industry,'' Journal of Money, Credit, and Banking,
22(2):221-233, 1990; E. Bruskin and M. Buono, ``A New Understanding
of Loss Severity: Time is (of) the Essence,'' in Mortgage Securities
Research, Goldman-Sachs, September 1994; and V. Lekkas, J. Quigley,
and R. Van Order, ``Loan Loss Severity and Optimal Mortgage
Default,'' AREUEA Journal, 21(4):353-371, 1993.
---------------------------------------------------------------------------
OFHEO is considering using a multivariate statistical model to
estimate the separate effects of these factors on severity. OFHEO may
develop a separate model for each of the cost and revenue components of
loss severity since each component is affected by different factors. In
the event that data on the individual revenue and cost components of
loss severity are unavailable, an alternative approach would be to
model overall loss severity directly.
Another less complex option is to estimate the individual
components without multivariate statistical analysis. OFHEO could set
fixed parameters for the components of severity--foreclosure costs
might be x percent of unpaid principal balance (UPB), carrying costs
equal to y percent of UPB and sales prices being z percent of UPB--
while allowing severity to vary based on, for example, the presence or
absence of private mortgage insurance or state foreclosure laws. The
simplest possible option would be to assume that all defaulted loans
face the same level of severity as a percentage of UPB.
There are a number of ways in which rates of loss severity may be
related to the stress benchmark rates of default and the corresponding
rates of default during the stress period. Given the impact of state
foreclosure laws on loss severity, default rates and loss severity will
be linked through the geographic location of the mortgages. For
example, loss severities are likely to be lower in states where
foreclosure laws are relatively more favorable to the lender.
The assumptions about changes in house prices in the stress
benchmark and during the stress period will affect the determination of
foreclosure sales prices and loss severity. Defaults are more likely to
have occurred when borrowers' properties have appreciated much less
than the average for their region. This implies that house price
indexes used to model loss severity would best be based on properties
that have experienced lower than average appreciation. [[Page 7475]]
Question 21: What are the explanatory factors OFHEO should consider
in modeling loss severity?
Question 22: Should OFHEO model the individual cost and revenue
components of severity or should OFHEO model only overall severity?
Question 23: What is an appropriate house price index for real
estate owned (REO) properties? In estimating foreclosure sales prices,
should OFHEO use a house price index based on all properties or a house
price index based only on REO properties?
E. House Price Indexes
The Act requires that OFHEO use house price indexes to determine
changes in the values of properties securing mortgages owned or
guaranteed by the Enterprises and the corresponding changes in LTVs.
Changes in property values are--
determined on an annual basis by region, in accordance with the
Constant Quality Home Price Index published by the Secretary of
Commerce (or any index of similar quality, authority, and public
availability that is regularly used by the Federal Government).\27\
\27\Section 1361(d)(1) (12 U.S.C. 4611(d)(1)).
Since the second quarter of 1994, the Enterprises have published
the quarterly Conforming Mortgage House Price Index (CMHPI) for the
nine Census divisions. This represents a significant improvement over
the annual four Census region Commerce Constant Quality Index (CCQI).
The CMHPI is based on a weighted repeat sales (WRS) approach in which
multiple transactions, i.e., mortgage originations, for individual
properties are matched by street address to obtain changes in sales
prices or appraisal values. Observed property values and transactions
dates are then combined in a multivariate statistical model to estimate
an index of housing values.\28\
\28\See W. Stephens, Y. Li, V. Lekkas, J. Abraham, C. Calhoun,
and T. Kimner, ``Agency Repeat Transactions,'' revised August 1994,
forthcoming in Journal of Housing Research (available from OFHEO).
---------------------------------------------------------------------------
OFHEO believes that a WRS index based on Enterprise data offers a
number of advantages for estimating the changing LTVs of the
Enterprises' mortgage assets. Perhaps foremost among these is the
direct correspondence between index data and the housing segment
serviced by the Enterprises. This factor, along with others, should
make the index more accurate for establishing the current market values
of properties securing mortgages held or guaranteed by the Enterprises.
In addition, a WRS index based on Enterprise data will allow OFHEO to
estimate changes in housing values at lower levels of geographic and
temporal aggregation, and with greater statistical precision, than the
CCQI allows. In order to meet the requirements of the Act regarding the
use of an alternative house price index, OFHEO will produce and publish
a similar house price index or indexes using data on the historical
mortgage transactions of the Enterprises.
Issues that have a bearing on the application of house price
indexes to the risk-based capital test include the appropriate level of
geographic aggregation, sample selection and appraisal bias, and the
effect of index revisions as new data becomes available.\29\
\29\Methodological issues related to the estimation of repeat
transaction house price indexes are discussed in the following
papers: M.J. Bailey, R.F. Muth, and H.O. Nourse, ``A Regression
Method of Real Estate Price Index Construction,'' Journal of the
American Statistical Association, 58:933-942, December 1963; K.E.
Case and R.J. Shiller, ``Prices of Single-Family Homes since 1970:
New Indexes for Four Cities,'' New England Economic Review, 45-56,
September/October 1987; K.E. Case and R.J. Shiller, ``The Efficiency
of the Market for Single Family Homes,'' American Economic Review,
79:125-137, 1989; J.M. Abraham, J.M. and W.S. Schauman, ``New
Evidence on Home Prices from Freddie Mac Repeat Sales,'' Journal of
the American Real Estate and Urban Economics Association, 19:333-
352, 1991; C.A. Calhoun, ``Estimating Changes in Housing Values from
Repeat Transactions,'' Federal National Association International
meetings (available from OFHEO); and C.A. Calhoun, P. Chinloy, and
I.F. Megbolugbe, ``Temporal Aggregation and House Price Index
Construction,'' Federal National Mortgage Association, forthcoming
in Journal of Housing Research (available from OFHEO); and B. Case,
H.O. Pollakowski, and S.M. Wachter, ``On Choosing Among House Price
Index Methodologies,'' Journal of the American Real Estate and Urban
Economics Association, 19(3):286-307, 1991.
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Geographical Aggregation
Aggregation across housing markets with imperfectly correlated
house price changes will result in biased estimates of the average
levels of appreciation in individual markets. This bias can be
characterized in terms of the smoothing of market-wide indexes, with a
corresponding increase in the apparent volatility of individual house
prices around the market index. Excessive disaggregation, however, may
reduce the frequency at which indexes can be meaningfully computed and
subject them to large revisions.
Question 24: What principles should OFHEO use in selecting the
optimal level of geographic aggregation for the stress test?
Bias
As discussed below, potential sources of statistical bias include
sample selection bias and appraisal bias.
Sample Selection Bias
Even within the total database of Enterprise mortgages, non-random
sampling of individual properties with repeat transactions could result
in an index that is biased for the larger population of Enterprise
properties. For example, the conforming loan limit and year-to-year
changes in the limit could result in sample selection bias in the
estimated parameters of a repeat transactions index. A closely related
form of sample selection bias can occur when the waiting time between
repeat transactions is correlated with the change in house prices. For
example, if more rapidly appreciating properties turn over within
shorter time intervals, they will appear in the repeat sample more
quickly. In this case, appreciation rates for repeat transactions near
the end of the sample period will not be representative. Thus, sample
selection bias would be greater near the end of the index.
Appraisal Bias
Approximately 85 percent of the repeat transactions used by the
Enterprises to estimate WRS house price indexes involve a refinance
transaction.\30\ Appraisals provide useful information on house values
in the absence of sales transactions. However, the use of appraisals in
real estate valuation is thought to impart bias by smoothing the
fluctuations in housing values. Appraisals are derived through
comparisons with properties that have either been sold or listed for
sale within the past several months and may fail to indicate more
recent changes in housing values.
\30\See Stephens, et al., supra.
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Question 25: Should house price indexes estimated using Enterprise
data include adjustments for identifiable sources of statistical bias?
Question 26: What additional sources of statistical bias exist and
what are possible corrective actions that may be taken to address them?
Question 27: What methods of accounting and correcting for sample
selection bias should be used?
Question 28: Should a statistical adjustment to the WRS house price
index be made to address the impact of appraisal bias?
Revision Volatility
As data on new transactions are obtained each quarter, new repeat
transactions can be combined with transactions that occurred in the
past. Thus, the quarterly index estimation process involves the
revision of the entire index in light of new information.
[[Page 7476]] Depending on the level of geographic aggregation, this
can result in substantial changes in historical values of the index and
the implied changes in the LTVs of Enterprise mortgages.
Question 29: Should changes in WRS indexes resulting from revision
volatility be reflected in indexes used in a stress test? If so, what
should be the frequency of such revisions?
F. Third Party Credit Issues
The Enterprises have credit exposure to institutions that provide
mortgage credit enhancements or that serve as counterparties to
derivative transactions. This exposure arises because the adverse
economic environment of the ten-year stress period may cause some
fraction of these institutions to fail and be unable to meet their
financial obligations to the Enterprises.
Credit Enhancements
The Enterprises reduce their exposure to mortgage credit losses
through a variety of credit enhancements that transfer some or all of
the risk to other parties. These credit enhancements include lender
recourse, mortgage insurance, and pool insurance.
The use of mortgage insurance illustrates how credit enhancements
work to mitigate credit losses and highlights some of the issues OFHEO
must address. Generally, the Enterprises may not purchase a
conventional mortgage whose LTV ratio exceeds 80 percent unless the
seller retains a participation interest or enters into a repurchase
agreement, or unless the mortgage is insured by a qualified
insurer.\31\ If insured mortgages experience actual losses, the
insurance fully or partially compensates the Enterprises for those
losses.
\31\Federal National Mortgage Association Charter Act, section
302(b)(2) and (5)(C) (12 U.S.C. 1717(b)(2) and (5)(C)), and Federal
Home Loan Mortgage Corporation Act, section 305(a)(2) and (4)(C) (12
U.S.C. 1454(a)(2) and (4)(C)).
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Applying an approach used by credit rating agencies for private
mortgage insurers, some insurers may be assumed to go out of business
during the stress period.\32\ To reflect this possibility, OFHEO's
stress test might assume the failure of some fraction of the private
mortgage insurers who would then be unable to entirely fulfill their
contractual obligations to the Enterprises.
\32\``S&P's Structured Finance Criteria,'' Standard & Poor's
(1988).
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Question 30: How should OFHEO calculate loss mitigation due to
credit enhancements?
Question 31: What should OFHEO assume about the scope of coverage
provided by credit enhancements?
Question 32: What assumptions should OFHEO make regarding the
failure of credit enhancements over the stress period?
Derivatives Counterparties
The Enterprises use non-mortgage derivatives--interest rate and
foreign exchange rate contracts--to hedge interest rate and foreign
exchange rate risk. Should a counterparty default on its obligation
under a derivative contract, an Enterprise may have to pay a new
counterparty to take on the remaining obligation.
Derivatives counterparties present some of the same issues as
credit enhancements. Generally, during an economic downturn, as one
counterparty's credit deteriorates, the other party to the transaction
may increase collateral requirements until eventually the value of
pledged collateral more than covers risk exposure. Therefore, with
prudent counterparty risk management, losses are most likely to occur
due to unexpected counterparty bankruptcies. Such losses may be more
directly related to potential financial market disturbances than to
general economic conditions.
Question 33: How, if at all, should OFHEO incorporate the effect of
counterparty defaults in the risk-based capital test?
G. Non-Mortgage Investments
The Enterprises maintain non-mortgage investment portfolios that
include Treasury securities, federal funds, time deposits, obligations
of states and municipalities, auction rate preferred stock, medium-term
notes, asset-backed securities, repurchase agreements, and other
instruments. At the end of the third quarter in 1994, these investments
totaled $11.5 billion at Freddie Mac and $35.1 billion at Fannie Mae.
On average in recent quarters, these investment portfolios have ranged
from two to five percent of assets plus MBS.
Many of these investments or their issuers are rated by the credit
rating agencies. Even though these are very short-term and liquid
investments, some of the issuers or the investments may be assumed to
default during the stress period. To reflect this possibility, OFHEO's
stress test might assume the failure of some fraction of the
investments or issuers, based on their credit rating.
Question 34: How should OFHEO simulate the default behavior of
investments or issuers of short-term, liquid investments?
Question 35: What assumptions should OFHEO make about the
performance of rated investments or issuers over the stress period?
Question 36: What assumptions should OFHEO make about gains and
losses on the sale of collateral for repurchase agreements?
II. Interest Rate Risk
Interest rate risk, associated primarily with the maintenance of a
retained portfolio, caused the most serious losses ever experienced by
the Enterprises. For a time during the early 1980's, Fannie Mae, which
was then almost exclusively a portfolio institution, was insolvent on a
mark-to-market basis.33 (Freddie Mac focused much more completely
on mortgage pass-through securities during that time period.) As did
much of the thrift industry at the time, Fannie Mae funded long-term,
low-yield, fixed-rate, single family mortgages with short-term
liabilities; rising interest rates drove up funding costs, causing
Fannie Mae to incur significant losses.
\33\The market value of Fannie Mae's liabilities (primarily
market-rate, short-term securities) exceeded the market value of its
assets (primarily below market-rate residential mortgages).
---------------------------------------------------------------------------
Since then, Fannie Mae and Freddie Mac (the latter has built a
substantial retained portfolio over the past decade) have developed
funding strategies that reduce their exposure to interest rate risk. To
protect against rising rates, liabilities have been lengthened to match
more closely the maturity of mortgage assets. When falling interest
rates result in accelerated mortgage prepayments, callable debt
structures now allow the Enterprises to retire some debt early or issue
new debt to maintain more closely their desired net interest margin.
Adjusting hedging strategies for adjustable-rate mortgage investments
presents a more difficult problem.
The Enterprises have recently been building mortgage derivative
portfolios that have an interest rate risk profile more complex than
those of whole mortgages.
Interest rate risk also affects income from the Enterprises'
securitization businesses. Float income--the return on invested
mortgage principal and interest payments prior to the corresponding
payment to investors--varies with the level of interest rates at which
the Enterprises reinvest such funds. Interest rates affect prepayment
rates, and changing prepayments affect float income at each Enterprise.
A number of issues related to the interest rate risk of the
Enterprises are discussed below. [[Page 7477]]
A. Yield Curve Construction
The Act provides specific instructions concerning the ten-year CMT
yield over the ten years of the stress test, but other points on the
Treasury yield curve are important as well. The Treasury yield curve
determines, directly or indirectly, the yields on adjustable-rate
mortgages, the returns on non-mortgage investments and the costs of
borrowing. The Act calls for Treasury yields of different maturities to
be determined in a way that is ``reasonably related to historical
experience and are judged reasonable by the Director.''34
\34\Section 1361(a)(2)(D) (12 U.S.C. 4611(a)(2)(D)).
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Question 37: How should OFHEO determine the remainder of the
Treasury curve and apply the curve through the ten-year stress period?
Question 38: How should the other points on the yield curve change
during the first year when the ten-year CMT yield is rising or falling?
Question 39: How, if at all, should those yields vary after the
one-year period when the ten-year CMT yield has reached its maximum or
minimum level?
B. Mortgage Prepayments--Interest Rate Risk
The financing of a mortgage portfolio presents one of the greatest
challenges of asset/liability management. A portfolio manager can
eliminate interest rate risk only if he or she issues liabilities with
maturities, rate adjustments, and embedded options matching those of
the mortgage assets. In a declining rate environment, should mortgages
pay down more quickly than liabilities, new low-yield mortgages added
to the portfolio will likely reduce the net interest margin; in a
rising rate environment, if liabilities run off more quickly than the
mortgage assets, the net interest margin will likely fall due to higher
funding costs.
Since the Enterprises absorb the credit risk of MBS, MBS dealers
and investors principally concern themselves with interest rate risk.
The tremendous volume of MBS outstanding, and the great sensitivity of
MBS value to interest rate movements and resulting prepayment rates,
have resulted in a significant research emphasis on prepayments by Wall
Street analysts. Although most Wall Street MBS pricing models focus on
prepayments, these models are estimated based on mortgage termination
data that do not distinguish prepayments from defaults. For the purpose
of modeling interest rate risk, the distinction is irrelevant.
The section above titled ``Models of Default and Prepayment''
suggests an approach to the stress test that combines the simulation of
defaults and prepayments in a joint multivariate model, making a
termination model unnecessary. Use of a mortgage termination model for
interest rate risk analysis runs the risk of generating implausible
patterns of prepayments because, depending on the approach to default
projections, defaults in some years of the stress period might approach
or exceed total projected mortgage terminations.
Question 40: What are the relative merits of the alternative
approaches, e.g., a joint multivariate default/prepayment model versus
a mortgage termination model, to modeling mortgage prepayments in the
stress test?
C. Liabilities
The Enterprises' liabilities may take the form of bonds and notes
with simple structures; so-called ``structured notes,'' possibly
combined with interest rate swap, cap or floor contracts; and foreign
currency denominated debt coupled with foreign exchange swap contracts.
Many bonds and contracts incorporate call or cancellation options,
respectively. Enterprise funding costs are affected by management
decisions to retire debt or cancel derivative contracts prior to stated
maturities, as well as decisions about the characteristics of debt
issued and derivatives activities initiated during the stress period.
Even though the initial stress test involves a ``winddown'' of the
Enterprises' businesses, decisions with respect to bond calls and
derivatives contract cancellations must be simulated. The financing of
mortgages purchased to fulfill contractual commitments may require the
issuance of new liabilities and possibly the initiation of new
derivatives contracts. The run-off of liabilities at a faster rate than
assets may also require new issuances.
Question 41: What should be the decision rules that OFHEO applies
in the stress test related to the exercise of bond calls and
derivatives contract cancellations?
Question 42: What should be the characteristics of simulated
liabilities issued by the Enterprises during the stress period, e.g.,
maturities, option structure, and coupon structure?
Question 43: What are the implications for simulated liabilities of
the pattern of interest rate movements modeled during the initial year
of the stress period?
D. Yield Curve Volatility and Option Pricing
The Act states that the ten-year CMT yield will be held at a
constant level for the last nine years of the stress period,35 but
remains silent on the volatility of the remainder of the Treasury yield
curve. Theoretically, the historical volatility of the yield curve has
some bearing on expectations of future volatility. Expectations of
future volatility, in turn, are a determinant of the current value of a
call option on debt.
\35\Section 1361(a)(2) (B) and (C) (12 U.S.C. 4611(a)(2) (B) and
(C)).
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Question 44: How does OFHEO implement the link between the
volatility of the yield curve experienced during the stress test and
the market's expectations of future volatility?
Question 45: What assumptions should OFHEO make about the speed
with which the Enterprises adjust to changes in volatility during the
stress period?
Question 46: If the actual volatility of yields experienced during
the stress test reaches extraordinarily low levels, what assumptions
should OFHEO make to ensure reasonable pricing and use of call options
on new debt?
E. Enterprises' Costs of Borrowing
As any organization depletes its capital reserves, the
organization's cost of borrowing increases due to its higher perceived
risk. Spreads over Treasury securities might also be affected by other
aspects of the stress period, including the sharp interest rate changes
early in the period and the prolonged general economic weakness.
Question 47: What techniques should OFHEO use to project the
Enterprises' borrowing costs? How should the stress test link capital
levels and quality spreads (borrowing rates relative to Treasuries)?
Question 48: Should yields relative to Treasuries widen during the
stress period in response to general interest rate changes or credit
problems? If so, by how much should they widen?
F. Hedging Activities
Hedging activities associated with structured notes, which convert
specific securities into a preferred debt structure, are addressed
above under ``Liabilities.'' The Enterprises engage in other hedging
activities to manage interest rate risk more generally. The Act
provides that:
Losses or gains on other activities, including interest rate and
foreign exchange hedging activities, shall be determined by the
Director, on the basis of available [[Page 7478]] information, to be
consistent with the stress period.36
\36\Section 1361(a)(4) (12 U.S.C. 4611(a)(4)).
Question 49: How should OFHEO simulate gains and losses (other than
those associated with counterparty failures) on derivative activities
in the stress test?
G. Investment of Excess Cash
Under certain circumstances, simulation of the stress scenarios may
require decision rules concerning the investment of excess cash. For
example, in the stress test scenario where the ten year CMT yield
falls, mortgage prepayments will increase. The proceeds from
prepayments of mortgages in the retained portfolio may exceed the cost
of retiring associated debt. Likewise, in the rising rate stress test
scenario, mortgages will prepay more slowly than in other scenarios.
Slower prepayments may lead to the receipt of more guarantee fee income
than initially anticipated on the Enterprises sold portfolio because
the mortgages remain outstanding longer than originally anticipated.
Since the Act does not permit the simulation of new business in the
initial stress test model, any excess cash generated during the stress
test period must be assumed to either be retained as cash or reinvested
in an interest-bearing asset.
Question 50: What decision rules should govern the investment of
excess cash during the stress period?
Question 51: What rate of interest should excess cash be assumed to
earn?
Question 52: Should excess cash be assumed to earn a single rate or
a weighted average rate, representing a range of possible investment
choices?
H. Other Indexes and Yields
Values must be created for other indexes and yields, e.g., the
Federal Home Loan Bank Eleventh District Cost of Funds Index and the
London Interbank Offer Rate, over the stress period in order to
reasonably project liability costs, as well as amortization,
prepayment, and default rates on affected adjustable rate mortgages.
One reasonable approach might be for OFHEO to create equations that
project these indexes based on their relationship to points on the
Treasury yield curve and assumed market conditions consistent with the
circumstances of the stress test.
Question 53: What techniques should be used to simulate the
behavior of these indexes and yields?
III. New Business and Other Considerations
OFHEO's risk-based capital test must incorporate a number of
decision rules to reflect management actions that would significantly
affect the financial performance of the Enterprises during the stress
period. Initially, the Act requires that OFHEO's stress test
incorporate no new business for the Enterprises during the stress
period other than the fulfillment of contractual commitments to
purchase mortgages or issue securities.37 The Act specifically
states that:
\37\Section 1361(a)(3) (12 U.S.C. 4611(a)(3)).
The characteristics of resulting mortgage purchases [and]
securities issued * * * will be consistent with the contractual
terms of such commitments, recent experience, and the economic
characteristics of the stress period.38
\38\Id.
The Act also requires that characteristics of the stress period other
than those discussed above in the ``Credit Risk'' and ``Interest Rate
Risk'' sections (such as, for example, dividend policies and operating
expenses) be determined by the Director, on the basis of available
information, to be most consistent with the stress period.39
\39\Section 1361(b)(2) (12 U.S.C. 4611(b)(2)).
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A. Commitments
At this time, the only ``new business'' OFHEO can assume during the
stress period is the fulfillment of contractual commitments to purchase
mortgages or issue new securities. As a regular business practice, the
Enterprises enter into commitments to purchase mortgages for periods
that may extend from a few weeks up to a year. The commitments specify
underwriting and pricing criteria for the mortgages to be delivered. If
the Enterprise intends to securitize the mortgages listed in the
commitment, then the Enterprise will hedge the commitment at the time
it is executed by selling the mortgages forward.
Often the seller/servicer that has agreed to sell to an Enterprise
under a commitment has not yet originated the mortgages at the time the
commitment is executed. When the seller/servicer actually delivers
mortgages, their characteristics may differ from those specified in the
original commitment.
Question 54: How should OFHEO define the term ``commitments''?
Question 55: On what basis, if any, should OFHEO simulate the
fulfillment of outstanding commitments?
Question 56: What mix of product types and underwriting qualities
should be assumed?
Question 57: What delivery timing should be assumed?
Question 58: What assumptions should be made with regard to
securitization versus retention in portfolio?
B. Dividend Policies
During the stress period, net income will fall, reducing cash
available for distribution to shareholders. In such circumstances,
Enterprise management might be expected to suspend dividends or reduce
the dividend rate. However, Enterprise management may be reluctant to
take such actions, because dividend reductions send a negative signal
to investors and would be expected to depress the market price of
Enterprise shares.
Question 59: Should OFHEO assume continuation of the present
dividend policies of each Enterprise for the entire stress period?
Question 60: If OFHEO simulates a reduction in the dividend payout
rate, at what point in the scenario should it take place?
Question 61: By how much should dividends be reduced if they are
reduced?
C. Operating Expenses
The Act is silent on how operating expenses should be treated in
the stress test, but OFHEO interprets the Act to require that OFHEO
model operating expenses in a manner most consistent with the stress
period. Operating expenses lower the Enterprises' earnings or increase
their losses, and thereby reduce their capital. The major portion of
operating expenses at each of the Enterprises consists of costs related
to personnel, occupancy, and equipment. Each Enterprise is divided by
business function, such as purchase of mortgages, credit analysis, and
investment management. Each Enterprise has regional offices. The
cessation of additional business at the commencement of the stress
period (beyond the fulfillment of contractual obligations) creates
conditions that would quickly eliminate some operations and gradually
reduce others.
Question 63: How should OFHEO appropriately model operating
expenses in the stress test?
Question 64: To what extent, if any, should operating expenses be
disaggregated and treated in distinct categories?
Question 65: How, if at all, should the stress test distinguish
between the Enterprises in their management of operating expenses
during the stress period? [[Page 7479]]
Conclusion
OFHEO has identified and highlighted many of the significant issues
that must be addressed in connection with development of the stress
test and the associated risk-based capital regulation. OFHEO seeks
comment on these and any additional issues that may be identified.
The development of the stress test and the risk-based capital
regulation is one of the critical statutory responsibilities of OFHEO.
In carrying out this responsibility, OFHEO is committed to a regulatory
process that will provide the broadest possible range of opinions from
the widest array of information sources for consideration during the
regulatory process. The development of the stress test and the
implementation of the risk-based capital regulation will provide
regulatory and analytical standards and tools that will safeguard the
financial safety and soundness of the Enterprises and in turn will
ensure that the Enterprises continue to accomplish their public
missions. Given the significance of this undertaking, OFHEO encourages
all interested parties to analyze the issues raised in this ANPR and
submit comments on the specific questions. OFHEO will thoroughly
analyze and carefully consider all comments during the course of the
development of the stress test and risk-based capital regulation.
Dated: February 2, 1995.
Aida Alvarez,
Director, Office of Federal Housing, Enterprise, Oversight.
[FR Doc. 95-3076 Filed 2-7-95; 8:45 am]
BILLING CODE 4220-01-P