[Federal Register Volume 66, Number 71 (Thursday, April 12, 2001)]
[Rules and Regulations]
[Pages 19048-19073]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-8923]



[[Page 19047]]

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Part IV





Farm Credit Administration





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12 CFR Part 650



Federal Agricultural Mortgage Corporation; Risk-Based Capital 
Requirements; Final Rule

  Federal Register / Vol. 66, No. 71 / Thursday, April 12, 2001 / Rules 
and Regulations  

[[Page 19048]]


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FARM CREDIT ADMINISTRATION

12 CFR Part 650

RIN 3052-AB56


Federal Agricultural Mortgage Corporation; Risk-Based Capital 
Requirements

AGENCY: Farm Credit Administration.

ACTION: Final rule.

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SUMMARY: This final rule amends Farm Credit Administration (FCA) 
regulations, through the Office of Secondary Market Oversight (OSMO), 
by establishing risk-based capital regulations for the Federal 
Agricultural Mortgage Corporation (Farmer Mac). The final rule in part 
650 sets forth the risk-based capital regulations for Farmer Mac, 
including definitions, methods, parameters and guidelines for 
developing and implementing the risk-based capital stress test. The 
final rule also specifies capital calculation, reporting, and 
compliance requirements; and delineates our monitoring, examination, 
supervisory, and enforcement activities with respect to Farmer Mac's 
compliance with the rule's risk-based capital requirements. Finally, 
the final rule prescribes certain requirements for business and capital 
planning.

EFFECTIVE DATE: This regulation will become effective 30 days after 
publication in the Federal Register during which either one or both 
houses of Congress are in session. We will publish a notice of the 
effective date in the Federal Register.

FOR FURTHER INFORMATION CONTACT:
Carl A. Clinefelter, Director, Office of Secondary Market Oversight, 
Farm Credit Administration, McLean, VA 22102-5090, (703) 883-4280, TDD 
(703) 883-4444,
    or
Dennis K. Carpenter, Senior Policy Analyst, Office of Policy and 
Analysis, Farm Credit Administration, McLean, VA 22102-5090, (703) 883-
4498, TDD (703) 883-4444,
    or
Joy Strickland, Senior Counsel, Office of General Counsel, Farm Credit 
Administration, McLean, VA 22102-5090, (703) 883-4020, TDD (703) 883-
4444.

SUPPLEMENTARY INFORMATION:

I. Objective

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

    Farmer Mac is a federally chartered instrumentality of the United 
States (U.S.) established on January 6, 1988, by the Agricultural 
Credit Act of 1987 (Pub. L. 100-233) (1987 Act), which amended the Act. 
Farmer Mac is a Government-sponsored enterprise tasked with the public 
policy mission of providing a secondary market for agricultural real 
estate loans. Farmer Mac is charged with increasing liquidity to rural 
lenders, increasing available long-term credit to farmers and ranchers 
at stable interest rates, and enhancing the ability of individuals in 
rural communities to get financing for moderately priced homes.

A. Legislative History

    Farmer Mac's statutory authority, established under title VIII of 
the Act, has been substantively amended several times since its 
origination in the 1987 Act. The 1991 amendments (Pub.L. 102-237) 
created OSMO and clarified FCA's authority, acting through OSMO, to 
regulate Farmer Mac. The 1991 amendments also set forth definitions for 
core capital,\2\ regulatory capital, and established minimum capital 
\3\ and critical capital \4\ levels. The 1991 amendments required us to 
develop and issue a risk-based capital stress test for Farmer Mac, 
which will establish risk-based capital requirements for Farmer Mac. 
The 1996 amendments (Pub.L. 104-105) prohibited us from establishing a 
risk-based capital stress test prior to February 10, 1999, 3 years 
following the effective date of those amendments.
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    \2\ ``Core capital'' is defined in section 8.31(2) of the Act as 
the sum (as determined in accordance with GAAP) of: (1) The par 
value of outstanding common stock; (2) the par value of outstanding 
preferred stock; (3) paid-in capital; and (4) retained earnings.
    \3\ Farmer Mac's ``minimum capital'' requirements are described 
under section 8.33 of the Act. The minimum capital level for Farmer 
Mac is an amount of core capital equal to the sum of: (1) 2.75 
percent of the aggregate on-balance sheet assets of Farmer Mac, as 
determined in accordance with GAAP; and (2) 0.75 percent of the 
aggregate off-balance sheet obligations of Farmer Mac which include: 
(a) The unpaid principal balance of outstanding securities that are 
guaranteed by Farmer Mac and backed by pools of qualified loans; (b) 
instruments that are issued or guaranteed by Farmer Mac and are 
substantially equivalent to (a); and (c) other off-balance sheet 
obligations. These minimum statutory capital standards will continue 
in effect after the risk-based capital rule becomes effective.
    \4\ Farmer Mac's ``critical capital level'' is described in 
section 8.34 of the Act. The critical capital level for Farmer Mac 
is an amount of core capital equal to 50 percent of the total 
minimum capital amount determined under section 8.33 of the Act.
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B. Overview of the Proposed Rule

    We published a proposed risk-based capital rule in the Federal 
Register on November 12, 1999 (64 FR 61740) for a 120-day comment 
period. At the request of Farmer Mac, we extended the comment period to 
June 12, 2000 (65 FR 9223, February 24, 2000).
    The risk-based capital stress test required by the Act determines 
the initial amount of regulatory capital necessary for Farmer Mac to 
preserve positive capital while undergoing stressful credit and 
interest rate risk conditions during a 10-year period. The Act also 
requires an added amount of capital to cover management and operational 
risks.
    Section 8.32 of the Act requires that the risk-based capital stress 
test subject Farmer Mac to credit losses on agricultural mortgages it 
owns or guarantees. The rate of loan default and severity of losses 
must be reasonably related to those experienced in contiguous areas of 
the U.S. containing at least 5 percent of the total U.S. population 
that experienced the highest rate of default and severity of 
agricultural mortgage losses during a historical period of at least 2 
consecutive years. We refer to this rate as the benchmark loss rate.
    The Act also requires us to incorporate in the risk-based capital

[[Page 19049]]

stress test an interest rate risk stress scenario based on rising and 
falling interest rates on Treasury obligations of various terms.
    In addition to the risk-based capital level required as a result of 
the credit loss and interest rate change components of the risk-based 
capital stress test, Farmer Mac is required to maintain additional 
capital to protect against management and operational risks. This 
additional capital level is specified in the Act as 30 percent of the 
capital level required for the sum of the credit loss and interest rate 
change components of the risk-based capital stress test.
    The Act also required us to develop risk-based capital regulations 
containing specific information on the requirements, definitions, 
methods and parameters used in implementing the risk-based capital 
stress test. This enables others to apply the test in a similar manner. 
Finally, we must make available to the public any statistical model 
used to implement the risk-based capital stress test.
    Although the risk-based capital stress test produces a dollar-
valued total regulatory capital requirement, it also creates marginal 
capital requirements. Incremental capital requirements based on the 
riskiness of each additional dollar of business for every type of 
product that Farmer Mac guarantees or holds in its portfolio are 
required through application of the test. Marginal capital requirements 
for mortgages held in portfolio will vary depending on the interest 
rate and credit risks associated with the mortgages as well as Farmer 
Mac's funding strategy. These marginal capital requirements may have 
significant bearing on how Farmer Mac implements its business 
strategies.
    We developed the risk-based capital stress test to reflect the 
risks inherent in Farmer Mac's various business activities. We 
incorporated, to the extent permitted by the Act, consistent 
relationships between the economic environment of the stress period and 
Farmer Mac's business activities. To do so required modeling Farmer 
Mac's assets, liabilities, and off-balance sheet positions at a 
sufficient level of detail to capture various risk characteristics.
    Our philosophy guiding the development of the risk-based capital 
stress test was that it should:
     Be consistent with the requirements of the statute, i.e., 
it should reflect worst-case credit conditions and interest rate 
movements, as defined in the Act;
     Reflect Farmer Mac's regulatory capital needs for credit 
and interest rate risks measured under stressful conditions;
     Be internally consistent;
     Not create inappropriate economic incentives;
     Aim for simplicity; and
     Reflect, to the extent practical and meaningful, Farmer 
Mac's current operating policies and practices.
    In developing the risk-based capital stress test, we engaged in 
three distinct activities that varied in complexity and time horizons:
     Identification of the benchmark loss experience;
     Construction of the risk-based capital stress test; and
     Examination and oversight.
    The final rule specifies the basic structure and parameters of the 
risk-based capital stress test and allows Farmer Mac to implement the 
stress test internally, using a model built according to our 
specifications, to determine its risk-based capital level.
    The goal of the risk-based capital stress test is to align capital 
requirements with risk and avoid creating incentives for Farmer Mac to 
engage in inappropriate risky activities. The stress test approach also 
provides greater flexibility to meet regulatory requirements than is 
available in traditional capital requirements. For instance, the stress 
test approach recognizes risk-mitigating activities. As an example, 
Farmer Mac may meet its risk-based capital needs by reducing risk and/
or increasing capital.

III. Summary of Comments Received

    We received six comment letters in response to the proposed rule. 
We received a comment letter from Farmer Mac, three from Farm Credit 
Banks (FCBs) who support the comments provided by Farmer Mac, one from 
the U.S. Department of the Treasury (Treasury), and a follow-up letter 
from Farmer Mac. The commenters generally supported the proposed rule 
and the risk-based capital stress test. However, the commenters did 
provide remarks on certain aspects of the proposed rule and stress 
test. These specific issues are discussed individually in the following 
sections of this preamble.

IV. Response to Comments on the Risk-Based Capital Stress Test

    The principal objective of the risk-based capital standard is to 
ensure that Farmer Mac has sufficient capital to remain solvent in the 
face of extreme stressful economic conditions. Therefore, we focused 
our efforts on developing a risk-based capital stress test to reflect 
the risks inherent in Farmer Mac's various business activities. We 
incorporated, as required by the Act, consistent relationships between 
the economic environment of the stress period and Farmer Mac's business 
activities. To do so required modeling Farmer Mac's assets, 
liabilities, and off-balance sheet positions with sufficient detail to 
capture the risk characteristics. However, we recognize that as the 
level of detail in the stress test increases so does its complexity and 
the time and resources required for its implementation. Thus, we worked 
carefully to maintain an appropriate balance between the model's 
complexity and its applicability.
    Overall, the commenters uniformly supported our efforts in 
developing a stress test for Farmer Mac that adheres to statutory 
requirements and contains an appropriate level of detail given Farmer 
Mac's current size and level of business activities. Farmer Mac noted 
in its comments that the FCA made significant strides toward the 
promulgation of a final rule that would comply with the terms and 
intent of the Act. Farmer Mac remarked that our most significant 
achievement was proposing a risk-based capital stress test with a high 
level of operational simplicity that can be performed using well-
defined data inputs in a spreadsheet format. We agree with the 
commenters that this approach helps us to meet the requirements of the 
Act that the model be made available for public review and eases the 
regulatory burden on Farmer Mac for performing the final risk-based 
capital stress test, at least quarterly, or as needed.
    Commenters also recognized the many challenges and limitations that 
we faced. Commenters realized that the task of designing and 
implementing an appropriate risk-based capital stress test is not 
simple. Farmer Mac identified numerous constraints on the development 
of the stress test, including conceptual and methodological issues 
relating to the limited availability and quality of historical data; 
model specification and estimation; and application of economic stress 
assumptions meeting the requirements of the Act. Farmer Mac added that, 
in many respects, we have succeeded in identifying and integrating the 
relevant sources of credit and interest rate risks into the risk-based 
capital model.
    Treasury also commented on the challenges we encountered in 
developing the risk-based capital stress test for Farmer Mac. Treasury 
cited two key constraints in measuring agricultural mortgage credit 
risk:
     Models of agricultural mortgage default are much less 
developed than those for residential mortgage default; and

[[Page 19050]]

     Available agricultural mortgage performance data are 
highly limited compared to those for residential mortgage performance.
    Treasury further commented that the lack of comprehensive 
literature on agricultural mortgage performance makes evaluation of the 
loss frequency model difficult. Treasury encouraged us to work with 
Farmer Mac and the Farm Credit System (FCS or System) in building a 
comprehensive agricultural mortgage database to help develop a better 
understanding of the determinants of agricultural mortgage performance.
    Commenters encouraged us to develop a conditional default model in 
future revisions to the stress test when more data become available. 
Commenters contend that many of the conceptual and statistical issues 
raised from the use of a lifetime default model would be reduced with a 
conditional default model, but conceded that current data limitations 
could create a different set of issues affecting the implementation of 
a conditional default model.
    We found that, from a statistical perspective, lifetime default 
models that used information based on origination and subsequent 
economic information were consistently more reliable than conditional 
default models. Specifically, the conditional models we reviewed were 
difficult to implement given that the Farm Credit Bank of Texas (FCBT) 
estimation data contained no updated information on underwriting 
variables through time or other ancillary conditioning variables. As a 
result, using the FCBT data to estimate a conditional model would 
require the reuse of independent underwriting variables at the 
origination values, or the development of other assumption-driven 
methodologies, to forecast conditioning variables through time. 
Repeating the same origination values during each year of a loan's life 
would not be an accurate reflection of loan performance through time 
and creates an artificial correlation among the independent variables. 
A true conditional model would be difficult to implement because the 
interest rate stress specified in the Act is a one-time instantaneous 
change to current interest rates. Whereas, both the current interest 
rate level and subsequent interest rate changes are likely to be 
significant drivers in a conditional model.
    We are committed to periodically evaluating the stress test and 
refining it to improve its effectiveness as a regulatory tool. However, 
a significant period of time may be needed to collect and analyze new 
data for the process of updating the risk-based capital stress test 
procedures. The ongoing nature of the risk-based capital stress test 
will enhance our understanding of how changes in Farmer Mac's business 
activities affect its risk profile and resulting capital requirements 
and help us identify needed improvements. We support the suggestion 
that we should work closely with other agricultural mortgage lenders to 
encourage the development of loan-level databases so that our 
understanding of the factors affecting agricultural mortgage 
performance will be enhanced.
    Although commenters provided general support for the proposed 
stress test, they also had a number of specific comments, objections 
and suggestions on certain components of the stress test. We have 
incorporated a number of changes into the stress test in response to 
the commenters' suggestions. The two most significant changes we 
incorporated were in response to comments received from Farmer Mac. As 
suggested by Farmer Mac, we modified our methodology for modeling the 
effect of loan size on the probability of loss and included the tax 
effect associated with gains and losses on marketable investments due 
to changes in interest rates. These changes, as well as others, are 
discussed in detail in the following responses to specific comments on 
the stress test components.

A. Credit Risk Component

1. Selection of a Stressful Economic Scenario for Land Value Change
    The Act requires that we determine the rate and severity of losses 
occurring in contiguous areas of the U.S., containing an average of not 
less than 5 percent of the population, and exhibiting the highest rate 
of default and severity of agricultural mortgage losses for a period of 
not less than 2 consecutive years. As explained previously, we refer to 
this rate as the benchmark loss rate. The Act further requires that the 
losses used in the stress test must be ``reasonably related'' to the 
benchmark loss rate. To identify the benchmark loss rate, we conducted 
extensive searches for historical agricultural mortgage data.
    We commissioned a study to identify the worst-case historical loss 
experience, as required by the Act. We published the study entitled 
``Risk-Based Capital Regulations for Farmer Mac: Loan Loss Estimation 
Procedures'' for comment in the Federal Register on July 28, 1998 
(Study).\5\ Farmer Mac commented on the Study, and we discussed those 
comments in the preamble to the proposed rule.
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    \5\ See 63 FR 40282.
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    We found two data sets with historic loan-level agricultural 
mortgage losses, one from the former St. Paul FCB and one from the 
FCBT.\6\ The Study identified the FCBT as the most reliable data 
source. Although the FCBT data was the most reliable, it did not 
represent the worst agricultural mortgage loss as required by the Act. 
Therefore, we used a statistical procedure of extrapolation to 
determine the worst-case loss experience.
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    \6\ In its comments, Farmer Mac agrees that the only available 
data for agricultural mortgage losses is in the former St. Paul FCB 
and the FCB of Texas.
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    To implement the extrapolation, we used accepted statistical 
approaches to estimate a relationship from the FCBT data using 
information observable in all regions in the U.S. We analyzed the 
relationship between land value changes and loss rates in the FCBT 
data. We then applied the relationship observed in Texas to other 
states to estimate loss rates in other regions. It is necessary to use 
sample data to estimate relationships that exist in the population. We 
used the FCBT data as a sample data set for understanding the 
relationship between the land value change and losses nationwide. The 
extrapolation process identified the worst-case agricultural mortgage 
loss region as Minnesota, Iowa and Illinois during the 2-year period of 
1983-1984.\7\
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    \7\ The extrapolation process yielded estimated historic time 
series of loan loss rates on Farmer Mac eligible loans for each 
state of the U.S. Using these historic data series, a ranking was 
compiled of 2-year loss rates for contiguous regions representing at 
least 5 percent of the 1990 U.S. population. The worst-case region 
contains Minnesota, Iowa and Illinois during the 1983-1984 time 
period with a 2-year loan loss rate of 4.18 percent.
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    The primary variable used in the extrapolation was the change in 
farmland values. The change in farmland value is also the primary 
variable used in the default equation of the risk-based capital stress 
test. We incorporated Farmer Mac's current risk characteristics with 
the extrapolated farmland value decline for the worst-stress time 
period to determine the benchmark loss rate.
    Farmer Mac provided several comments related to the proposed use of 
the stressful economic scenario for land value change derived from the 
Study. Farmer Mac asserts we proposed applying a credit stress 
scenario, based on the Study, that does not meet the requirements of 
the Act. Farmer Mac also contends the Study contains empirical and 
methodological shortcomings that invalidate both the

[[Page 19051]]

proposed benchmark region and the related land value decline.
    Farmer Mac proposed an alternative benchmark region and related 
credit stress scenario based on data from the FCBT without 
extrapolation. Farmer Mac believes its method is fully consistent with 
the Act and can be validated by actual credit loss data. Three FCBs 
supported Farmer Mac's comments on the benchmark loss issue and use of 
the FCBT data without extrapolation as the benchmark loss data.
    Farmer Mac also commented that we did not adequately respond in the 
proposed rule to its comments on the Study. We believe we have been 
fully responsive to Farmer Mac. In the preamble to the proposed rule, 
we responded directly to Farmer Mac's comments that were relevant to 
how the Study was used in the proposed stress test. In addition, 
following publication of the Study, we provided Farmer Mac additional 
information on, and an explanation of, the Study in response to its 
questions and comments. We also met with Farmer Mac on many occasions 
to discuss the Study and other stress test issues.
a. Historical Loan Loss Data and Consistency With the Act
    Farmer Mac commented that actual default and loss experience do not 
substantiate the proposed benchmark loss information because loss data 
for Farmer Mac-eligible loans do not exist for the three-state region 
identified as the benchmark region. Farmer Mac asserted that the Study 
does not meet the requirements of the Act because Congress mandated the 
use of actual, historic loss rates and not estimated rates. Farmer Mac 
suggested two alternatives to using actual, historic loss rates. Farmer 
Mac stated that we could have used the former St. Paul FCB data as the 
benchmark loss data. Alternatively, Farmer Mac contended that the FCBT 
data represented the worst-case agricultural mortgage loss data and are 
usable without estimation. Finally, Farmer Mac compared FCA's task to 
that of the Office of Federal Housing Enterprise Oversight (OFHEO) and 
asserted that OFHEO rejected the use of estimated data as the benchmark 
loss data.
    First, we respond to Farmer Mac's comment that we could have used 
the St. Paul data as the benchmark loss experience. We do not believe 
the St. Paul data represent clear, definable losses that would be 
suitable for use in the stress test. The St. Paul FCB used loan workout 
techniques, such as restructuring and forbearance, that resulted in 
fewer foreclosures. As a result, losses were spread out over longer 
periods of time, operating expenses reflected higher loan management 
and forbearance costs, and earnings were reduced from rate concessions. 
In addition, loan restructurings resulted in some direct losses from 
partial debt forgiveness. Consequently, the direct charge-offs reported 
in the loan data from the St. Paul FCB region do not represent total 
regional losses.
    Also, some areas of the St. Paul district were subject to a 
foreclosure moratorium for a portion of the sample period. In order to 
use the St. Paul data, we would have had to determine the impacts that 
forbearance procedures had on lending costs. We would also have had to 
use lost earnings as proxies for the loan loss rates to use the St. 
Paul data for the stress test. We determined that using the St. Paul 
data would not have been feasible given the large number of assumptions 
necessary to construct appropriate measures of credit loss from the St. 
Paul data. The FCBT did not use restructuring and forbearance to any 
substantial degree. The FCBT recorded immediate, quantifiable losses, 
making the data more reliable and verifiable, which results in a more 
reliable and verifiable stress test than if the data from the former 
St. Paul FCB were used.
    Next, we respond to Farmer Mac's comment that we could have used 
the FCBT data without extrapolation. Farmer Mac claimed that use of the 
FCBT data without extrapolation is appropriate for the following 
reasons: The Act requires actual historical losses rather than 
estimated data; the FCBT data are the worst-case data (rather than 
Iowa, Illinois, and Minnesota); and the Texas losses are higher than 
any that might be seen in the future.
    In initial comments on the Study, Farmer Mac asserted that the Act 
requires the FCA to use the FCBT data as the worst-case agricultural 
mortgage losses because it believes the Act requires the use of actual, 
historic losses rather than estimated losses. We responded to this 
comment in the proposed rule. As stated in the preamble to the proposed 
rule, the Act directs us to use the worst-case experience, not simply 
the worst-case data that are available. We continue to believe that 
using an extrapolation process permits us to reasonably identify the 
worst-case region as required by the Act.
    We concluded that Texas was not the region in the U.S. with the 
worst-case loan losses based on the well-documented geographic 
distribution of financial stress and losses experienced by both farmers 
and agricultural lenders. In fact, the historical geographic 
distribution of farm financial stress and loan performance problems 
show that the greatest stress occurred in the Corn Belt, Lake States, 
and Northern Plains regions in 1984. Support for this conclusion is 
provided in the experience of the System, financial assistance provided 
by the Financial Assistance Corporation (FAC), and in an Economic 
Research Service (ERS) report entitled ``Loan Repayment Problems of 
Farmers in the Mid-1980s.'' \8\ Based on an analysis of allowance for 
loan losses, the FCS experience of credit stress shows that the FCBT 
was the sixth worst of the eight Farm Credit banks.\9\ In addition, 
substantial FAC assistance was provided to several FCBs other than the 
FCBT.\10\ Lastly, the ERS report concluded that Texas ranked fourth 
worst for farms most affected by financial stress during 1984 to 1986 
and third from 1987 to 1989. The report also consistently identified 
the upper Midwest as the focal point of farm stress in the 1980s, a 
result that is consistent with the findings of the Study. This evidence 
clearly shows that the State of Texas did not experience the worst 
historical agricultural mortgage losses.
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    \8\ Hanson, G., A. Parandvash, and J. Ryan. Loan Repayment 
Problems of Farmers in the Mid-1980s, AGR Report No. 649, ERS, USDA, 
1991.
    \9\ Although more than 8 banks existed in the 1980s, this 
ranking is expressed in terms of the banks in existence at the time 
of the Study.
    \10\ FAC provided assistance to four banks in the amounts of $90 
million for the FCB of Louisville, $133 million for the FCB of St. 
Paul, $107 million for the FCB of Omaha, and $89 million for the FCB 
of Spokane. The financial assistance was provided to strengthen 
their capital positions and for other purposes.
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    Farmer Mac's contention is that the FCBT data must be used because 
the losses are higher than any losses that are likely to occur in the 
future. A comparison of the historic losses to ``possible'' future 
losses is not a relevant consideration for determining the benchmark 
loss rate in the Act. The benchmark losses must be higher than other 
losses experienced in history, not in the future, in order to be used 
as the benchmark for the stress test.
    Finally, we believe that Farmer Mac's comparison of the benchmark 
used by OFHEO and the proposed stress test benchmark is invalid. 
Accurate, quantifiable data reflecting a wide geographic scope of 
housing mortgage losses are available to OFHEO to determine the worst-
case benchmark housing mortgage losses. Despite an exhaustive search, 
we were not able to identify accurate, quantifiable, and geographically 
broad data to directly identify the agricultural mortgage loss

[[Page 19052]]

benchmark other than the Texas data. Thus, a comparison of our use of 
extrapolation and the lack of extrapolation by OFHEO is not 
appropriate.
    After considering these comments, we are making no changes to the 
final rule in this area.
b. Underwriting Screens Applied to the FCBT Data
    In the Study to determine the benchmark loss rate, we used 
underwriting standards in order to screen the Texas data and identify 
loans in that portfolio that could be considered ``qualified loans'' 
for Farmer Mac's programs under the Act. Farmer Mac commented that the 
underwriting screens applied to the historical FCBT data in the Study 
were different from those used in estimating the loss-frequency 
equation in the proposed rule.\11\ As a result, Farmer Mac stated that 
the Study included loans inconsistent with Farmer Mac's current 
underwriting practices. Farmer Mac stated that the benchmark worst-case 
land value decline was invalid because it was developed using 
underwriting standards different from those used to estimate the loss-
frequency equation used in the stress test. We address consistency with 
Farmer Mac's current loan-underwriting practices in a later section 
entitled ``Data Screens Applied in Estimating the Loss-Frequency 
Equation.''
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    \11\ The loss-frequency equation is often referred to by 
commenters as the default model, lifetime default model or credit 
loss model. However, we use the term ``loss-frequency equation'' 
throughout because the equation was estimated based upon the 
occurrence of a loss in the screened FCBT data and not the 
occurrence of a default.
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    Farmer Mac is correct that different underwriting screens were used 
in the Study and in estimating the loss-frequency equation in the 
stress test. To respond to the comment, we analyzed the FCBT data using 
data screens consistent with those used in the loss-frequency equation 
estimation.\12\ Based on this analysis, we concluded that using either 
set of data screens leads to the selection of the same worst-case 
region and explanatory variable of land value change. Because the 
explanatory variable is the same, the ranking of the State-level losses 
is unchanged. The worst-case region remains Minnesota, Iowa, and 
Illinois during 1983-1984. Therefore, the 23.52 percent average 2-year 
land value decline for the worst-case region is an appropriate 
stressful input to use in the risk-based capital stress test and is 
consistent with the underwriting screens used in the risk-based capital 
stress test. It is not necessary to make any changes to the final rule 
because the use of different screens in the Study does not change the 
outcome of the Study.
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    \12\ See Farmer Mac's June 12, 2000, comment letter for the data 
presented in the column of Table 2 that represent the loan charge-
off rates based upon data screens used for the estimation of the 
loss-frequency equation.
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    Based on Farmer Mac's comment on the Study, we reviewed all aspects 
of the credit risk estimation procedures to ensure that consistent 
underwriting screens were applied throughout the stress test. As a 
result, we made a technical modification to the loan-seasoning 
adjustment as discussed in the later section entitled, ``Miscellaneous 
Technical Changes.''
c. Other Technical Comments on the Study
    The proposed rule generated numerous comments on technical aspects 
of the Study, other than those already discussed. We address these 
comments in this section.
    Farmer Mac commented that the FCBT data used to estimate the loss-
frequency equation must be from the 2-year worst-case benchmark time 
period. Farmer Mac further observed that this benchmark is based on a 
worst-case land value decline occurring in 1984 and 1985 before losses 
occurred in the FCBT data. We believe Farmer Mac misunderstood the 
relationship between the benchmark land value change used in the stress 
test and the estimation and application of the loss-frequency equation 
in the stress test. There is no requirement for the time periods to be 
identical. The losses for other regions are based on maximum land value 
declines that occurred at different points in time, so the difference 
in timing is not consequential. Thus, the time period of losses 
occurring in the FCBT data set is not relevant to the use of the land 
value decline in the risk-based capital stress test.
    Farmer Mac further suggested that a better approach would be to use 
the land value decline in Texas of 16.69 percent that actually occurred 
during the time period of the FCBT data. However, this land value 
decline is significantly less than those occurring elsewhere in the 
nation. As we have previously discussed, we know that other regions 
experienced greater losses than those that occurred in Texas. To comply 
with the Act, we must use the land value decline input in the stress 
test that corresponds to the worst-case historical agricultural 
mortgage losses.
    Farmer Mac also noted that in the proposed rule, we recognized that 
the proposed land value decline of 23.52 percent exceeded the 16.69-
percent decline occurring in the FCBT data used to estimate the loss-
frequency equation. Farmer Mac claimed the use of a land value decline 
exceeding the decline found in the estimation data could result in 
unreasonably large loss rates. Farmer Mac suggested that we use the 
16.69-percent land value decline as the stressful input in the loss-
frequency equation, rather than the proposed adjustment for restricting 
the slope of the loss-frequency equation, to account for the 
possibility of unreasonably large loss rates.
    We respond that the 16.69-percent FCBT land value decline is not 
the worst-case that occurred. The proposed 23.52-percent land value 
decline is more appropriate and consistent with the requirements of the 
Act. Restricting the slope of the loss-frequency equation is a 
reasonable approach to address the nonlinear nature of the loss-
frequency equation when using inputs beyond those observed in the 
estimation data. We did, however, slightly adjust the technical 
calculation of the slope adjustment for other reasons as discussed in 
the later section entitled, ``Miscellaneous Technical Changes.''
    Farmer Mac further commented that the application of the land value 
decline in the risk-based capital stress test is unnecessarily complex. 
Although our approach for restricting the slope of the loss-frequency 
equation is somewhat complicated, it directly addresses the difference 
between the 23.52-percent land value decline that occurred in the 
worst-case region and the maximum 16.69-percent land value decline that 
occurred in the FCBT data used to estimate the loss-frequency equation. 
We conclude that the proposed approach is an appropriate application of 
the stress scenario in the risk-based capital stress test and that it 
complies with the Act's requirement to use the worst-case region in the 
stress test. Thus, we made no changes to the benchmark land value 
decline as a result of these comments.
    Although we are making no changes to the benchmark land value 
decline specification, we will study any new agricultural mortgage loss 
information and update the benchmark loss rate as appropriate. We note, 
however, that replacing the extrapolated benchmark data with direct, 
verifiable data requires the agricultural mortgages in a region 
(meeting the statutory criteria) to experience a loss situation that 
mirrors or exceeds the farm crisis of the 1980s. If such a loan loss 
situation occurs, we will examine loan portfolio data from Farmer Mac, 
the FCS, and other agricultural lenders in considering any changes.

[[Page 19053]]

2. Distribution of Credit Loss by Exposure Years
    After determining the rate and sensitivity of loss to apply in the 
stress test, we had to determine a reasonable way to apply that stress 
over the 10-year period. We proposed to distribute age-adjusted 
lifetime losses through time on a deterministic path that provides a 
stressful scenario. The proposed deterministic time path for converting 
from origination year to exposure year credit losses was 43 percent in 
year one, 17 percent in year two, 16 percent in year three, and 3.4 
percent in each of the last 7 years.
    Farmer Mac raised a number of conceptual issues with the proposed 
methodology for distributing credit losses by exposure year and 
suggested an alternative solution. Among the concerns Farmer Mac raised 
with our proposed approach were:
     Using single-year events appears to be inconsistent with 
the Act. The Act requires the use of a 2-year period for applying rates 
of default in the stress test.
     The loss allocation pattern aggregates and redistributes 
loan loss into a deterministic path in a manner that did not occur in 
history. The distribution of losses is not representative of any actual 
exposure year loss experience of loan cohorts in the FCBT data. 
Instead, it selectively concentrates the historical experiences of 
different loan cohorts across a range of exposure years into a single 
year of the stress test.
     The allocation method does not control for truncated 
default and loan loss effects, which could cause the losses to be 
biased upwards in origination years with limited default information.
     The distribution of the losses is inconsistent with the 
beta loss distribution used to derive State-level seasoned adjusted 
loan loss. The redistribution of loan losses obscures the relationship 
between loan age and the timing of loan losses established by the beta 
loss distribution.
    Each of these concerns is addressed in turn in the following 
discussion.
    First, we believe Farmer Mac has mistakenly concluded that the 2-
year time period requirement in the Act applies to the distribution of 
losses in the stress test. The Act requires that the frequency and 
severity of loan losses used in the stress test must reasonably relate 
to a benchmark historical loss period of at least 2 consecutive years. 
We have complied with the 2-year requirement in the Act by using the 
land value decline from the 2 worst loss years, as determined by the 
Study, in the credit loss model to determine the loss frequency rate 
used in the stress test. The Act does not, however, prescribe how we 
must distribute the loss frequency over the 10-year stress period. 
Therefore, we applied a reasonable methodology to determine the most 
appropriate way to allocate the benchmark loss stress over the 10-year 
stress period required by the Act.
    Second, Farmer Mac commented that the loss allocation pattern 
aggregates and redistributes loan loss into a deterministic path in a 
manner that did not occur in history. Section 8.32 of the Act does not 
require the allocation pattern to exactly replicate a specific 
historical pattern.\13\ The Act requires that the rate be ``reasonably 
related'' to the historical data. Accordingly, we constructed a 
stressful allocation pattern that is reasonably representative of the 
historical data. In developing the stress test, we were required to 
identify a reasonable, but stressful pattern of losses. Among the 
choices considered in developing the proposed rule were to: (i) Place 
all origination losses into a single-exposure year; (ii) estimate a 
function to capture the time dependence observed in portfolio-level 
losses; (iii) sort in descending order from the maximum observed losses 
in any given cohort-exposure year as the sequence of maximum possible 
stress to minimum stress and take the top 10 (normalized to sum to 
one), or; (iv) use empirically guided descriptors from the limited data 
on losses available to construct a plausible, but stressful loss 
pattern.
---------------------------------------------------------------------------

    \13\ Also, using the 7-year historical pattern found in the 
historical data directly as the loss pattern would not account for 
the allocation of losses over the entire 10-year period of the 
stress test.
---------------------------------------------------------------------------

    In constructing the loss-allocation pattern, the limitations of the 
data led to our choice of the fourth approach, appropriately relating 
the FCBT data to the stressful conditions employed in the stress test.
    Farmer Mac and other commenters also pointed to the significant 
data problems as barriers to implementing certain theoretical 
approaches. The data provide a relatively short loss observation 
window, and the observed loss levels contain unknown total lifetime 
losses. Thus, we concluded that simply taking the 7 years of data as 
the only possible loss values and arranging them into a specific time 
pattern that represents stress was not the most realistic method to 
characterize the stressful conditions required by the Act. We selected 
an average of the maximum 1-year, 2-year, 3-year, and so on, loss rates 
as the method to allocate losses. We used the cohort-weighted average 
of the individual loss rates to control for the influence on the 
relative loss rates of the shorter observation window of the latter 
originations. As a result, no individual loss rate observations were 
used independently from cohort-weighted averages to determine the loss 
pattern. This procedure prevents a single individual observation from 
becoming the maximum used to determine the exposure-year loss pattern. 
As a result, this procedure avoids the use of the maximum individual 
exposure-year loss occurrence of 91 percent observed in the data as the 
maximum loss rate when determining the exposure-year loss pattern.
    Third, Farmer Mac also stated that the proposed allocation method 
does not control for truncated default and loan loss effects. The 
potential truncation bias referred to by Farmer Mac should be viewed 
relative to the overall application of losses within the stress test. 
Losses are estimated using a loss-frequency equation that only included 
losses observable in the data window. We believe it would not be 
appropriate to forecast loan activity occurring outside of the 7-year 
time period of the data set. As a result, the observed losses were 
truncated for loans with remaining lives at the end of the observed 
data window, including loans originated near the end of the data 
window. We believe the methodology selected to allocate losses into 
exposure years is appropriate due to the limitations of the available 
data.
    Fourth, Farmer Mac suggested that the distribution of the losses is 
inconsistent with the beta-loss distribution used to derive State-
level, age-adjusted loan loss totals. It contended that the 
redistribution of loan losses obscures the relationship between loan 
age and the timing of loan losses established by the beta distribution. 
In response, we note that the State-level loss totals are based on 
loans that are individually age-adjusted using a beta distribution as 
the seasoning function. The beta distribution was not estimated from, 
nor intended to reflect, the portfolio-level pattern of those losses 
through time. The loan-level ``unconditional'' seasoning effects 
(wherein cohorts were pooled across origination time in estimation) are 
not the same as the explicitly ``conditional'' time period effects 
(explicit dependence on a specific time period) that result in non-
uniform, loss-allocation patterns at the portfolio level. Thus, we 
believe use of the beta distribution is not the appropriate method to 
control allocations of portfolio-level losses

[[Page 19054]]

through time. Whereas, using different distributions for the loan 
seasoning and allocation effects is a logical and consistent 
application in the stress test. These two functions are inherently 
separate and it is not appropriate to apply the same distribution for 
both effects. We are not adopting Farmer Mac's comment in the final 
rule.
3. Data Screens Applied in Estimating the Loss-Frequency Equation
    Our objective in determining the loss-frequency equation is to 
estimate the relationships between loss frequency and the independent 
variables that help explain loss frequency. Farmer Mac's comment raised 
concerns with the data screens used to select FCBT farm mortgages for 
estimating the loss-frequency equation. Generally, Farmer Mac contended 
that the data screens are not representative of its current loan 
underwriting practices and, therefore, the data includes loans Farmer 
Mac would not make today. Before we address Farmer Mac's specific 
concerns with the data screens, we first summarize the proposed data 
screens.
    As noted in the proposal, the FCBT farm real estate loans used to 
estimate the loss-frequency equation had to satisfy at least three of 
four underwriting standards. This approach was intended to include 
estimation data encompassing ranges of data observed or potentially 
observed in Farmer Mac's current portfolio. The four data screens 
specify that: (1) The debt-to-asset (D/A) ratio must be less than 0.50; 
(2) the loan-to-value (LTV) ratio must be less than 0.70; (3) the debt-
service-coverage ratio (DSCR) must exceed 1.25; and, (4) the current 
ratio (current assets divided by current liabilities) must exceed 1.0. 
Farmer Mac's procedures permit it to waive complete compliance with its 
underwriting standards if a loan is judged to have appropriate 
offsetting strengths. Accordingly, in our approach, we required that 
loans satisfy at least three of the four specified data screens. In 
addition, we restricted the D/A and LTV ratios to be less than or equal 
to 0.85.
    Farmer Mac objected to our use of the three-out-of-four screening 
approach and the use of D/A and LTV ratios less than or equal to 0.85. 
Farmer Mac contended that the screening was incorrect because it 
misinterprets Farmer Mac's loan underwriting standards and practices. 
Farmer Mac's standards and practices ensure that any one standard 
exception/deficiency is duly offset by a compensating surplus/strength 
in another standard. It argues that the high LTV loans found in its 
portfolio relate solely to part-time farmer loans, which have 
additional compensating factors mitigating risk exposure. Farmer Mac 
referenced its policy of restricting the purchase of full-time farm 
loans with LTVs greater than 0.70.
    Prior to publishing the proposed regulation, we reviewed portions 
of Farmer Mac's loan portfolio and found several instances where D/A 
and LTV ratios exceeded 0.50 and 0.70, respectively, with values of 
both ratios rarely exceeding 0.85. In the Farmer Mac data reviewed, 3.3 
percent of the loans and 3.1 percent of the outstanding loan balances 
had LTV ratios exceeding 0.70. In response to Farmer Mac's comment, we 
reviewed and evaluated Farmer Mac's current loan portfolio 
characteristics for the 3 most recent quarters to determine if the 
screening criteria were appropriate. In our review of the March, June, 
and September 2000 Farmer Mac loan portfolios, we found numerous loans 
with LTV ratios greater than 0.70 that were to full-time farmers. For 
instance, at September 30, 2000, Farmer Mac's loan portfolio included 
5.7 percent of loans and 3.0 percent of the origination loan balances, 
where the LTV ratios exceeded 0.70.\14\ Of this group, 0.7 percent of 
loans and 1.1 percent of origination loan balances were full-time 
farmer loans. Part-time farmer loans with LTV ratios exceeding 0.70 
represented 5.0 percent of loans and 1.9 percent of origination loan 
balances. We also found several instances of full-time farmer loans 
where D/A ratios exceeded 0.50. Given the characteristics of loans in 
Farmer Mac's portfolio, we conclude that the proposed data screens are 
reasonably consistent with its current underwriting practices. 
Therefore, we did not modify the data screens in the final rule.
---------------------------------------------------------------------------

    \14\ All loan portfolio percentages are based on origination 
loan volume.
---------------------------------------------------------------------------

    We further note that the data screens used permit the estimation of 
the relationships across the entire range of data observed in Farmer 
Mac's portfolio. For instance, the use of the maximum values for LTV 
and D/A and the three of four standards requirement is intended to 
include data in the estimation sample that ``could'' occur in Farmer 
Mac's portfolio. Having a complete data set for estimating the loss-
frequency equation is essential to appropriately estimate the 
relationships between underwriting variables and the frequency of loss.
    We must apply a varied set of data screens to the FCBT data because 
Farmer Mac uses a varied set of underwriting practices based on the 
economic environment and other subjective factors. More importantly, 
the econometric methods we used to estimate the relationships between 
independent variables use nonlinear specifications of some variables. A 
rich data set is needed to estimate the nonlinear relationships and 
should include, if available, data across the entire range in which the 
relationship will be applied. Restricting the data to only data that 
met all underwriting criteria at any given time could restrict the 
estimation of the nonlinear relationship as well as exclude data that 
could be used to estimate the relationships. The data screens used 
provide a data set sufficiently rich to correctly estimate the loss-
frequency equation, including the nonlinear relationships. The data 
screens result in selection of FCBT loans that span all observed 
underwriting characteristics found in Farmer Mac's portfolio.
4. Specification of the Loan-Size Variable Used in the Loss Frequency 
Model
    We proposed using several variables to determine losses in the 
risk-based capital stress test. Specifically, we use a multivariate 
model to project credit losses. One of the proposed explanatory 
variables used in the loss-frequency model is loan size (SIZE) 
expressed in 1997 dollars. This variable is stated in absolute dollars, 
whereas all other variables are expressed as ratios (D/A and DSCR) or 
percentages (LTV and LANDVAL).\15\ The LTV variable is represented as a 
nonlinear power function and LANDVAL is discounted by the age of the 
loan at the time of the maximum land value decline.
---------------------------------------------------------------------------

    \15\ LANDVAL refers to the maximum percentage land value 
decline.
---------------------------------------------------------------------------

    Farmer Mac commented that the loan-size variable disproportionately 
impacts projected loss frequency, regardless of the values of other 
underwriting variables, such as LTV and DSCR. Farmer Mac noted that for 
large loans, the loan-size variable dominates the lifetime default 
relationship and results in unrealistically high rates of default, even 
at low values of LTV and high values of DSCR. Farmer Mac stated that 
the estimated coefficient of SIZE is positively biased for relatively 
small and relatively large loans. Farmer Mac commented that loan size 
dominates the impacts of all the other explanatory variables for larger 
loans and causes the model to project extremely high loss frequency.
    For these reasons, Farmer Mac suggested we re-estimate the loss-
frequency model using a nonlinear specification for the loan size 
variable,

[[Page 19055]]

consistent with the treatment of other variables such as LTV and 
LANDVAL. Farmer Mac explained that including this nonlinear 
specification for the impact of loan size on the lifetime probability 
of loss frequency improves the ability of the stress test to measure 
the actual risks of Farmer Mac's business.
    We agreed with Farmer Mac's general assessment regarding the use of 
the linear specification for loan size and re-evaluated its use in the 
stress test. During the development of the model, we originally adapted 
and accepted the linear specification from Farmer Mac's preliminary 
modeling efforts to maintain some consistency with Farmer Mac's 
independent modeling efforts. We found that a linear specification of 
the loan size was adequate for use in the stress test because it 
generally had the desirable intuitive and statistical properties. The 
proposed specification was consistent with our observation that large 
loans resulted in higher loss frequencies and could have a material 
adverse impact on an institution due to size. After further analysis in 
response to the comment, however, we found that the FCBT data supported 
the use of a nonlinear specification for the SIZE variable. Although we 
observed that measured losses increase as loan size increases, the 
actual loss rate does not increase linearly with loan size. Thus, we 
re-estimated the model using a nonlinear estimation procedure to 
simultaneously estimate coefficients and nonlinear parameters for the 
model. Similar to maximum likelihood techniques for solving standard 
logit problems, this procedure minimizes the likelihood function.
    We made nonlinear transformations to three independent variables: 
(1) LTV, (2) maximum land price decline, and (3) loan size. A 
functional form is required of each nonlinear variable. We chose the 
same forms as proposed for LTV and maximum land price decline. The 
functional form selected for loan size incorporates the observed 
relationship between loan size and frequency of default. The FCBT data 
suggest that frequencies of loss increase as loan size increases, but 
the rate of loss frequencies tends to increase at a decreasing rate as 
loan size increases. Within this relationship, the amount of dollar 
losses always increases as loan size increases. The form of the 
transformation we chose is:

1-exp(-8  Age-adjusted loan size)

    The size of 8 impacts the change in the loss 
frequency rate relative to the change in loan size. The transformation 
results in lower loss rates for both small and large loans as compared 
to the proposed loss-frequency equation. For smaller loans, a given 
change in loan size has a greater impact on loss rates than for larger 
loans.
    The following table displays the estimated dollar losses and loss 
rates for various sized sample loans from the application of: (1) The 
proposed model, (2) the model suggested by Farmer Mac, and (3) the 
revised model (final rule).

----------------------------------------------------------------------------------------------------------------
                                 Proposed rule loss amount/ FAMC example loss amount/   Final rule loss amount/
       Loan size  (000's)               rate  ($/%)                rate  ($/%)                rate  ($/%)
----------------------------------------------------------------------------------------------------------------
$50............................  $531/1.063                 $222/0.444                 $142/0.284
100............................  1,106/1.106                444/0.444                  644/0.644
300............................  3,894/1.298                10,231/3.410               9,880/3.293
500............................  7,601/1.520                31,070/6.214               26,533/5.307
750............................  13,859/1.848               46,604/6.214               46,823/6.243
1,000..........................  22,387/2.239               62,139/6.214               64,945/6.495
2,500..........................  158,136/6.325              155,349/6.214              164,521/6.581
5,000..........................  789,818/15.796             310,698/6.214              329,042/6.581
----------------------------------------------------------------------------------------------------------------
Notes: Loan size is shown in thousands and loss rates are shown as percentages. We calculated the estimated
  dollar losses and rates by varying the origination principal balance for an individual loan with the following
  characteristics.
Loan Origination Year: 1996.
Loan Age: 4 years.
LTV at Origination: 0.5.
D/A at Origination: 0.5.
DSCR at Origination: 1.3984.
Percentage Land Value Change: -23.52.
Loss severity: 20.9%.
Dampening factor: 4.133%.

    The table shows that the final rule loss-frequency equation results 
in dollar losses and loss rates comparable to the example equation that 
Farmer Mac supplied and supported in its comments. As discussed 
previously, the dollar losses and loss rates increase at a decreasing 
rate and, thus the impact of a change in loan size on loss rates is 
greater for smaller loans. As shown in the table, dollar losses and 
loss rates increase significantly as the size of the origination 
principal outstanding changes from a small amount (e.g., $50,000) to a 
moderate amount (e.g., $300,000). As anticipated, the table further 
shows that dollar losses and loss rates increase at a lower rate as 
origination principal loan size changes from a large amount 
($1,000,000) to a very large amount ($2,500,000). The model presented 
by Farmer Mac has a fixed ceiling on loss rates for loans greater than 
$500,000, whereas the loss rates in the final rule equation increase by 
an ever-smaller amount as loan size increases.
    As can been seen in the table, the originally proposed 
specification caused dollar losses and loss rates to increase 
significantly at larger loan sizes. By comparison to the final rule, 
the proposed specification may have understated losses on moderately 
sized loans and may have overstated losses on larger sized loans--a 
point made by Farmer Mac in its comment letter. The nonlinear 
relationship is supported by the FCBT data and is consistent with 
expectations. Overall, the treatment of loan size adopted in the final 
rule provides a better specification of the relationship between loan 
size and losses.
5. Use of a Constant Loss-Severity Rate To Determine Credit Losses
    We proposed a constant loss-severity rate of 20.9 percent on all 
mortgages in Farmer Mac's portfolio. The loss-severity rate was 
calculated by taking the average loss rate of defaulted loans in the 
FCBT data, weighted by loan volume. To calculate expected age-adjusted 
lifetime losses on individual loans, the loss-severity rate is 
essentially multiplied with loss-frequency

[[Page 19056]]

probability, origination loan size, and an appropriate age-adjustment 
factor.\16\ We selected the constant severity rate after determining 
that the FCBT data provided insufficient evidence to the contrary. No 
significant statistical relationship was found between loss-severity 
rates and various independent indicators in the FCBT data.
---------------------------------------------------------------------------

    \16\ The example calculation of expected age-adjusted lifetime 
losses contained in Appendix A to subpart B, is separated into 
numerous steps for illustrative purposes. However, mathematically, 
several steps of the example calculation can be combined into a 
single step that calculates dollar losses by multiplying the final 
slope-adjusted loss frequency probability, loss severity, 
origination loan amount, and the appropriate age adjustment.
---------------------------------------------------------------------------

    Farmer Mac and the FCBs objected to using a loss-severity rate of 
20.9 percent for all mortgages. Principally, commenters noted industry 
practice of varying loss-severity rates to account for different credit 
risk profiles of mortgages, especially LTV ratio categories. Although 
Farmer Mac acknowledges that the FCBT data may not provide the expected 
relationships between the loss-severity rate and LTV ratios, it 
contends that industry practice and academic research clearly indicate 
that these relationships exist. Farmer Mac further commented that 
applying a constant loss-severity rate would discourage risk-based 
pricing and suggests all borrowers would be charged the same interest 
rate, contrary to efficient market theories. Additionally, Farmer Mac 
commented that loss-severity rates on older loans, or loans with low 
original LTVs, are much lower due to the higher levels of borrower 
equity.
    Farmer Mac suggested applying at least three different loss-
severity rates, based on groupings of LTV ratios, as an alternative to 
the constant loss-severity rate for all mortgages. Farmer Mac provided 
independent research on agricultural mortgage losses and recommended a 
loss-severity rate of:
     20.9 percent for mortgages with an LTV greater than 60 
percent.
     10.5 percent for mortgages with an LTV ranging from 40.01 
to 60 percent.
     Zero for mortgages with an LTV that is less than or equal 
to 40 percent.
    Farmer Mac presented no data to support this suggested application. 
Applying the average loss-severity rate to only the highest LTV 
category would result in lower total losses than supported by FCBT 
data.
    Prior to publishing the proposed regulation, we met with Farmer Mac 
to discuss an approach for determining a loss-severity rate to use in 
the credit risk component of the stress test. Farmer Mac had also 
evaluated the FCBT data to determine whether a relationship existed 
between LTV and loan losses. Based on its own analysis, Farmer Mac 
concluded that the data were insufficient to estimate an acceptable 
loss-severity rate and concurred that when a richer data set becomes 
available, the loss-severity rate should be re-estimated. At that time, 
and based on its earlier efforts, Farmer Mac suggested a constant loss-
severity rate of 20 percent may be appropriate based on its approach of 
averaging the loss-severity rate on defaulted loans that met its 
criteria in the FCBT data. We generally accepted Farmer Mac's initial 
approach.
    It may be conceptually appealing to assume that loans with lower 
LTV ratios have lower loss rates than loans with higher LTV ratios. It 
may also be logical to assume that the equity buffers provided by 
borrowers help reduce loss exposure. We understand that residential 
mortgage research indicates different loss-severity rates should be 
applied to mortgages with different LTV ratios. As such, we carefully 
evaluated the proposal presented by Farmer Mac.
    We found that the Farmer Mac proposal, which only applies the 
average loss-severity rate to the suggested top LTV category (i.e., 
loans with LTV ratios greater than 60 percent), understates the 
expected total losses on Farmer Mac's loan portfolio, particularly 
compared to the losses found in the historical estimation data. To 
correct for this understatement, we analyzed loss-severity levels found 
in the FCBT data for the LTV categories suggested by Farmer Mac.
    We performed additional analysis of the statistical relationship 
between LTV and loss-severity rates. Our data analysis confirmed the 
earlier results that there is no statistically significant relationship 
between LTV and loss-severity rates in the FCBT data. Therefore, we 
were unable to develop a statistically supportable method using 
available data to apply different loss-severity rates to various ranges 
of LTV ratios. In our analysis, the loss-severity rates we might have 
applied to various ranges of LTV ratios would have been arbitrary and 
without sufficient supporting data. We could have selected other 
approaches to loss severity, such as using the highest loss-severity 
rates observed by the data or the highest loss-severity rates over a 2-
year period. However, such approaches would have produced extremely 
large expected credit losses not reasonably related to the historical 
FCBT data.
    We also reviewed the study cited by Farmer Mac in support of its 
argument for varying loss-severity rates by LTV ratios on agricultural 
mortgages.\17\ The study was intended to demonstrate the application of 
option theory to default. The analysis was based on changes in land 
values and did not reflect actual default or loss experienced by 
borrowers. The study was set up to show a certain outcome in a pre-
determined way, and did not ``find'' that LTV is related to loss rates, 
only that such a relationship is assumed to exist in its model.
---------------------------------------------------------------------------

    \17\ See, DeVuyst, C.S., E.A. DeVuyst, and T. G. Baker. 
``Expected Farm Mortgage Default Cost'' Agricultural Finance Review, 
Vol. 55, 1995 pp. 10-22.
---------------------------------------------------------------------------

    For the reasons noted above, we continue to believe that a constant 
20.9-percent loss-severity rate, on average, reasonably reflects credit 
risk stemming from all agricultural mortgages in Farmer Mac's 
portfolio. Accordingly, the final rule requires Farmer Mac to use a 
20.9-percent loss-severity rate for estimating loan losses on all its 
agricultural mortgages in its portfolio. When a more extensive data set 
becomes available, we will consider if the loss-severity rate should be 
re-estimated and evaluate other approaches to estimating the loss-
severity rate on all loans.
6. Comparison of Actual to Predicted Losses Using Revised Loss-
Frequency Equation and Unchanged Constant Loss-Severity Rate
    As explained above, in response to comments received, we revised 
the loan size specification in the loss-frequency equation. We 
evaluated the revision by comparing the actual and estimated loss rates 
and amounts for all the FCBT loans for the years 1979 to 1992. To 
estimate the losses, we applied the revised loss-frequency equation, 
the unchanged constant 20.9-percent loss-severity rate, the appropriate 
maximum land value decline, and the loan-seasoning adjustment to the 
FCBT loan-level data. We then compared the estimated losses to actual 
losses observed in the actual FCBT data.
    The comparison revealed that the revised loss-frequency equation 
and unchanged loss-severity rate performed well in replicating losses 
contained in the actual FCBT data. The predicted results are comparable 
to the actual loss rates and amounts found in the FCBT data. Our 
analysis estimates total losses over the entire sample period to be 
$10,341,616. Actual losses incurred total $9,805,472. The average of 
the predicted loss rates is 0.52 percent from 1979-1992, while the 
average of the actual rates is 0.50 percent. The maximum 1- and 2-year 
actual loss rates

[[Page 19057]]

in the FCBT data are 1.54 percent and 2.17 percent in 1985 and 1984-
1985, respectively. The maximum 1- and 2-year loss rates estimated by 
the model are 1.26 percent in 1986 and 2.42 percent in 1985-1986.
    To predict the losses, we applied the revised loss-frequency 
equation, the unchanged 20.9-percent loss-severity rate, ``actual Texas 
land price declines'', and the loan-seasoning adjustment. At the loan 
level, the largest discrepancies between the actual and predicted loss 
rates and amounts occur on loans originated in 1986 and 1987. As 
expected, many of the loan-level discrepancies are partly associated 
with using an average loss-severity value. Using an average loss-
severity rate underestimates predicted losses on specific loans that 
have actual severity rates exceeding 20.9 percent and overestimates in 
other instances. However, at the portfolio level, using a weighted 
average loss-severity rate produces consistent results in predicted 
total portfolio loss rates and total-portfolio-dollar loss amounts.
7. Approximating Mortgage Performance Through Time
    We used a dampening effect to reflect the econometric relationship 
between the land value change and the point in time in the life of a 
loan where loss is experienced. The dampening effect helps provide an 
appropriate structural representation of mortgage performance for the 
purpose of determining stressful credit losses.
    Treasury asserted that the stress test contains two adjustment 
factors for loan age in the calculation of losses. Treasury stated that 
the first age adjustment is a result of applying the dampening factor 
to land value changes. The second is the loan-seasoning adjustment, 
which is applied after the constant loss-severity rate and loss 
frequency for a loan are combined to determine unseasoned dollar 
losses.\18\ Treasury stated that these age effects could be estimated 
differently. Treasury suggested we estimate current LTV instead of 
using the original LTV.\19\ Treasury explained that it may be possible 
to use loan-term information to amortize the origination balance 
through time to approximate the current LTV by updating the original 
property value. Treasury further commented that such a rough 
approximation might be conceptually more appropriate than making an 
adjustment to the effect of the decline in farmland values. 
Alternatively, Treasury suggested that a farmland price index that 
explicitly accounts for appreciation, if available, might be used. 
Treasury also suggested that loss severity and loan age could be more 
seamlessly tied together by directly relating loss severity, loan age 
at default and the origination LTV. We provide the following 
clarifications in response to Treasury's comments.
---------------------------------------------------------------------------

    \18\ As discussed earlier, the maximum land value decline is 
dampened to reflect the effect that a land-value decline has on the 
loss-frequency probability given when the decline occurs in a loan's 
life. Separately, the calculation of dollar losses is adjusted for 
the effects of loan seasoning.
    \19\ Treasury's comment is based on the fact that the historical 
estimation data contains only values for underwriting variables at 
origination and not throughout the life of a loan. As a result, the 
historical data do not directly contain the necessary information to 
implement a different approach.
---------------------------------------------------------------------------

    Treasury incorrectly indicated that the decline in the value of the 
property securing a 4-year old loan is assumed to be 4.3 percent (23.5 
percent less the product of 4.8 percent and 4 years). Instead, the 
dampened decline in value of such a property is 19.5 percent (23.5 (1 + 
0.048) - 4 = 19.5).\20\ This calculation preserves much of the land 
value decline assumed in the model and provides a more appropriate 
model.
---------------------------------------------------------------------------

    \20\ See Proposed Risk-Based Capital Rule, Appendix A, Step 4, 
64 FR 61759, November 12, 1999.
---------------------------------------------------------------------------

    We believe that Treasury may have misinterpreted the dampening 
effect. We use a dampening effect to reflect the econometric 
relationship between the land value change and the point in time in the 
life of a loan that loss is experienced. Specifically, the 23.5-percent 
decline in agricultural real estate values is the stressful exogenous 
economic input in determining credit losses used in the stress test. 
When applying this land value decline in the loss-frequency equation, 
it is dampened for each year a loan has been in existence. This 
dampening of the stressful land value decline input is consistent with 
the relationship observed in the FCBT data of the effect of a land 
value decline on loss frequency. This relationship represents the 
impact that the timing of the land value change has on the loss-
frequency probability. The dampening effect, however, does not take the 
place of the loan-seasoning effect on losses. The dampening effect also 
has no impact on loss severity.
    Treasury asserted that the proposed loan-seasoning adjustment 
applied in conjunction with the constant average loss-severity rate 
gives Farmer Mac a substantial cushion. We do not believe the loan-
seasoning adjustment provides Farmer Mac with a substantial cushion. In 
the model, we use average loss severity and the loss-frequency 
probability to determine the expected lifetime dollar losses before 
adjusting for loan seasoning. We then apply the loan-seasoning 
adjustment to provide an appropriate level of expected age-adjusted 
lifetime losses for use in the stress test. As a result, our approach 
appropriately considers the relationship between loan age and dollar 
loan losses. As previously discussed, the approach we used estimates 
losses that are comparable to the actual losses found in the historic 
FCBT data when stressful agricultural conditions occurred. There is no 
clear evidence of a substantial cushion being provided to Farmer Mac in 
our approach to predict age-adjusted lifetime dollar losses. Instead, 
the approach provides a level of stressful credit losses to use in the 
stress test that is reasonably related to actual historic losses.
    Treasury further commented that, in reality, the loss-severity rate 
of 20.9 percent is actually the maximum loss severity. We generally 
agree with Treasury's observation. We note that the loss-severity rate 
is simply a fixed number, uniformly applied to all loans. The loss-
severity rate is a constant and is not related to other variables. 
Thus, by its very construct, the rate is the maximum loss severity, and 
in fact the only loss severity, that can occur on an individual loan. 
As noted above, using a fixed loss-severity rate supports the 
calculation of an appropriate level of stress expected due to credit 
losses at the portfolio level. The term ``average loss severity'' was 
meant to be generally descriptive of how the loss-severity rate was 
determined from the FCBT data. We conclude that the use of the term 
``average'' continues to be appropriate and that no change in the final 
rule is required.
    We are unable to implement Treasury's suggestion to estimate the 
loss relationship to current LTV because the necessary loan terms are 
not available in the FCBT data. Therefore, it is not possible to 
directly calculate amortization schedules and prepayment patterns. We 
continue to believe that the use of the original LTV is more valid than 
an estimated LTV. The use of an estimated LTV depends on assumptions 
about changes in land value, interest rates, repayment arrangements, 
and other factors. In contrast, the use of the original LTV does not 
require such assumptions. We continue to believe that our approach 
effectively integrates loss-frequency probability, loss-severity, and 
loan-age effects.
8. Treatment of Long-Term Standby Loan Commitments
    Farmer Mac commented that the proposed rule has an inconsistency in

[[Page 19058]]

the calculation of the State-level loss rates for non-standby loans and 
standby loans. The proposed calculation for non-standby loans is total 
dollar losses divided by total ``origination'' loan balances for each 
State. Whereas, the calculation for standby loans is total dollar 
losses divided by ``current'' loan balances for each State. As a result 
of this difference in calculation, Farmer Mac contends that the model 
overstates the credit risk on standby loans. Farmer Mac suggested we 
modify the model to calculate the State-level loan loss rate for 
standby loans and non-standby loans in the same manner. The calculation 
Farmer Mac would use is the total dollar loan losses divided by 
``origination'' loan balances, rather than ``current'' balances.
    Given the purpose of the loss calculation, we cannot adopt Farmer 
Mac's suggestion. The primary purpose was to determine the dollar 
amount of losses to be applied in the stress test. The conversion to a 
loss rate was made for convenience to facilitate the calculation of 
expected age-adjusted lifetime losses in a separate spreadsheet named, 
``Credit Loss Module. XLS.'' The loss rates were then copied to the 
spreadsheet called the ``FAMC RBCST,'' which is the spreadsheet that 
calculates the regulatory capital requirement under the stressful 
conditions required by the Act.\21\ Our intent was always to apply loss 
rates in the FAMC RBCST spreadsheet that would produce a dollar amount 
of age-adjusted lifetime losses consistent with the amount estimated in 
the credit loss module component of the stress test.
---------------------------------------------------------------------------

    \21\ The Credit Loss Module and FAMC RBCST spreadsheets are 
separate components of the stress test.
---------------------------------------------------------------------------

    Based on our analysis, the suggested change would misrepresent the 
loss rate on standby loans since the estimated losses are already 
adjusted for loan seasoning and tend to reflect the benefit of 
principal amortization that has occurred.\22\ The following table 
illustrates this point.
---------------------------------------------------------------------------

    \22\ The loss rate for non-standby loans are also adjusted for 
loan seasoning and tend to reflect the benefit of principal 
amortizations that have occurred.

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                       (5)  Age-                 (7)  Age-
                                                                                                        adjusted                  adjusted   (8)  Losses
                                                                   (2)                                   losses    (6)  Losses     losses     applied to
                                                               Origination      (3)       (4)  Age-    divided by   applied to   divided by    determine
                          (1)  Year                             principal     Current      adjusted     current      determine  origination   regulatory
                                                                 balance      balance       losses      balance     regulatory     balance    capital as
                                                                                                          (in        capital        (in       suggested
                                                                                                        percent)                  percent)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1............................................................     $100,000      $97,815       $2,664         2.72       $2,664         2.66       $2,606
2............................................................      100,000       95,455        2,442         2.56        2,442         2.44        2,331
3............................................................      100,000       92,906        1,853         1.99        1,853         1.85        1,721
4............................................................      100,000       90,153        1,114         1.24        1,114         1.11        1,005
5............................................................      100,000       87,180          525         0.60          525         0.53         458
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes: The table shows the annual calculation of dollar losses and loss rates using both current and origination principal balances. The table also
  shows the dollar losses that would be applied to determine regulatory capital. The calculations in the table assume a hypothetical Farmer Mac
  portfolio consisting of only one standby loan originated in 1999 with an original principal balance of $100,000. The columns of the table are:
 Column 1 shows the year for the annual calculation.
 Column 2 of the table shows the origination principal balance.
 Column 3 shows the current principal balance as a result of principal amortization.
 Column 4 shows the age-adjusted origination year estimated losses for each subsequent annual calculation of the credit loss module.
 Column 5 shows the loss rate that would be calculated in the credit loss module component.
 Column 6 shows the dollar losses the FAMC RBCST would determine when calculating regulatory capital.
 Column 7 shows the loss rate calculated using Farmer Mac's suggested methodology.
 Column 8 shows the dollar losses that FAMC RBCST would determine using loss rates calculated following Farmer Mac's suggested methodology.

    The eighth column of the table demonstrates that the suggested 
approach would understate the age-adjusted origination year loss rates. 
This result occurs because the calculated loss rates are applied to 
current principal balances outstanding in the FAMC RBCST component of 
the stress test. The current principal balances outstanding are based 
on the data input requirement of using the most recent quarterly 
financial statements for running the model. On Farmer Mac's financial 
statements, seasoned agricultural mortgage loans are not shown at 
origination value, but reflect principal amortizations made over time. 
Therefore, it would not be an appropriate application in the stress 
test to use origination principal loan balances to calculate loss rates 
as doing so understates the dollar amount of estimated losses.
    However, we agree that the calculation of loss rates for standby 
and non-standby loans should be consistent. Consistency is needed to 
ensure the estimated age-adjusted lifetime loan loss rates are 
correctly calculated to replicate the right amount of dollar losses 
throughout the stress test. Rather than modify the calculation for 
standby loans as suggested by Farmer Mac, Appendix A of subpart B 
includes changes in the calculation of the loss rates for non-standby 
loans. In the final model, total dollar loan losses are divided by 
total ``current'' loan balances for each State to derive the State-
level loss rate for both standby and non-standby loans in Farmer Mac's 
portfolio. The technical correction in the calculation of loss rates 
for non-standby loans ensures that the right amount of expected losses 
are applied in the stress test. The change in the calculation of loss 
rates for non-standby loans is discussed in detail in section IV.C.3 
and Appendix A of subpart B of this rule.
9. Institutional Credit Risk
    Treasury commented that we should include Farmer Mac's 
institutional credit risk exposure in the risk-based capital stress 
test. Treasury stated that Farmer Mac is exposed to institutional 
credit risk from a number of sources: AgVantage bonds; non-mission 
investments; sellers and servicers; and interest rate contract 
counterparties. Although Treasury agreed with us that these risks are 
currently limited, Treasury does not believe that the statutory 30-
percent add-on for management and operations risks covers the 
institutional credit risks. Treasury also suggested that the risk-based 
capital requirements established by the Federal banking agencies and 
the OFHEO for

[[Page 19059]]

insured depositories and Fannie Mae and Freddie Mac, respectively, 
should provide useful guidelines.
    We proposed to capture Farmer Mac's institutional credit risk 
exposure through the 30-percent management and operations risk add-on 
provided in the Act. In response to Treasury's comment, we reviewed 
Farmer Mac's institutional credit risk relating to AgVantage bonds, 
sellers' and servicers' activities; other investments held by Farmer 
Mac and interest-rate contract counterparties. We found that Farmer Mac 
effectively manages its institutional credit risk exposure through 
appropriate policies and practices. We noted no increase in the level 
of institutional credit risk exposure since publication of the proposed 
rule.
    As suggested by Treasury, we could develop and apply a risk-
adjustment factor for institutional credit risks arising in the future, 
using several sources as guides, including the treatment by other 
financial regulators of such risks. We do not believe, however, that we 
can realistically predict how Farmer Mac's institutional credit risk 
may change in the future. Instead, we would have to determine an 
adjustment to apply to Farmer Mac's portfolio based on sources other 
than data specific to Farmer Mac's risks. At this time, adopting a risk 
factor adjustment to apply to Farmer Mac's portfolio would be an 
unnecessary step. The 30-percent add-on in the Act is clearly designed 
to capture risks such as those that are not measurable from historic 
benchmark agricultural mortgage losses. Congress has in essence, chosen 
a set percentage to apply in such situations. Therefore, we believe it 
is inappropriate to artificially add another factor that is not based 
on actual risk data.
    We believe a better approach is to continue to monitor Farmer Mac's 
institutional credit risks. If we see changes in the nature of these 
risks, we can make adjustments to the stress test to capture them. This 
continuing approach to monitoring and addressing Farmer Mac's 
institutional credit risks is preferable to trying to capture possible 
future risks today. We will continue to monitor these risks and take 
regulatory action, including expedited rulemaking if warranted, at the 
appropriate time to address these risks.
    We made no changes in the final rule in response to this comment.

B. Interest Rate Risk Component

    We proposed a two-pronged interest rate risk test, combining 
stochastic market value of equity estimation with a deterministic 
steady-state cashflow projection. As part of the interest rate 
component of the stress test, we estimated the change in Farmer Mac's 
market value of equity in order to estimate the impact of an interest 
rate shock on Farmer Mac's net income over a 10-year period. To 
estimate the impact, we computed the effective duration of Farmer Mac's 
assets, liabilities and off-balance sheet instruments under each 
interest rate shock. The duration estimates were then used to calculate 
the estimated market value change in equity in the stress test.
    Although the commenters generally supported our proposed approach 
of using Farmer Mac's internal risk models, they commented on, and 
requested changes to, several aspects of the proposed methodology. In 
response to commenters' suggestions, we incorporated several changes to 
the interest rate risk component of the stress test. Those changes and 
our response to specific comments are discussed below.
1. Timing of the Stressed Change in Interest Rates
    The stress test is initialized with data from Farmer Mac's most 
recent historic quarter-end balance sheet. In the model, the starting 
position is identified as t \0\. Subsequent annual accounting cycles 
are represented consecutively as t \1\ to t \10\. The model applies the 
stress test conditions required by the Act and builds pro forma 
financial statements that include the effects of the stress conditions.
    Treasury commented that the change in interest rates should be 
applied at starting period (t \0\) rather than the first period (t 
\1\). Treasury observed that Farmer Mac generates earnings (from t \0\ 
to t \1\) on the amount of the interest rate risk that is not 
recognized until period t \1\.
    We generally agree with Treasury's observation that there is an 
earnings effect associated with not posting the interest rate shock to 
the starting balance sheet, t \0\. We are further convinced that the 
stress test should reflect the effects of an interest rate change that 
occurs prior to period t \1\. Changing the interest rates prior to 
period t \1\ is more consistent with our goal of developing a stressful 
interest rate scenario that complies with the Act.
    Therefore, we modified the interest rate shock calculation to 
include an earnings effect.
    After careful analysis, we determined the earnings effect based on 
the assumption that the change in interest rates occurs mid-way in the 
annual income cycle from t \0\ to t \1\. Under this approach, the 
market value reduction in capital occurs at the end of the sixth month, 
which is halfway between periods t \0\ to t \1\. At month six, Farmer 
Mac's capital position decreases by the market value reduction and its 
liabilities increase by the same amount. However, rather than re-state 
Farmer Mac's balance sheet at month six, we capture the earnings 
effects by multiplying the market value change with Farmer Mac's 
annualized cost of funds and dividing by 2, as if the rates changed in 
the sixth month. This approach avoids unnecessary complications to the 
stress test and the confusion that may result from showing an inter-
period balance sheet. Capital at t \1\ is then adjusted to reflect the 
earnings effect. The interest rate shock posted to the balance sheet 
now reflects a market value change in equity and earnings effect, 
assuming rates change during the middle of the accounting cycle. As a 
result, starting in t \1\, the earnings effect is fully reflected in 
the structure of the balance sheet.
2. Tax Effects of the Market Value of Equity Change From the Stressed 
Change in Interest Rates
    In the proposed rule, we did not include the impact of taxes for 
the change in the market value of equity. Farmer Mac commented that the 
change in market value of equity for the interest rate risk portion of 
the stress test should be adjusted to reflect the effect of taxes 
before the increase or decrease is recorded to equity. Farmer Mac 
explained that accounting for the tax effects of market value gains and 
losses is consistent with GAAP treatment of unrealized holding gains or 
losses on available-for-sale assets under Statement of Financial 
Accounting Standards (SFAS) No. 115 and SFAS No. 109.
    We concur that the estimated market value of equity change due to 
the stressful interest rate movement should include the effect of 
taxes, and we modified the stress test accordingly. This change more 
closely aligns the economic realities and accounting treatment 
resulting from changes in, or to, market value of equity. However, we 
placed some limitations on the amount of tax benefits that can be 
recorded during the stress test. The potential tax benefits of the 
unrealized market value loss in equity are captured in a similar manner 
as other financial institution regulators treat deferred-tax assets 
(DTA) in their regulatory capital requirements.\23\
---------------------------------------------------------------------------

    \23\ For FCA's treatment of DTAs, see 12 CFR 615.5120; for the 
Federal Deposit Insurance Corporation (FDIC), see 12 CFR 325.2 and 
325.5; the Office of the Comptroller of the Currency (OCC), 12 CFR 
3.2 and Appendix A to part 3, sections 1 and 2; the Federal Reserve 
Board (FRB), 12 CFR 208, Appendix A, section B; and for the Office 
of Thrift Supervision (OTS), Thrift Bulletin 56--Regulatory 
Reporting Of Net Deferred Tax Assets, January 20, 1993.

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

[[Page 19060]]

    Generally, tax affects on available-for-sale securities are 
determined by multiplying the estimated unrealized market value loss by 
an enterprise's effective tax rate. As a result, a deferred tax asset 
is recorded. For regulatory capital purposes, DTAs may be included in 
the regulatory capital calculation if: (1) They are expected to be 
realized within the next 12 months; (2) they can be used to recapture 
taxes previously paid; or (3) they may reduce tax obligations 1 year 
into the future. We limit inclusion if DTAs exceed a specified level of 
certain components of capital.
    Within the context of the stress test, we are treating the tax 
benefit of the unrealized market value loss in a manner that is 
similar, but not identical to, the other regulators' treatment of DTAs. 
Our approach differs in that we only address the potential DTAs that 
could arise from the unrealized loss in market value of equity as 
determined in the stress test. We exclude existing DTAs as immaterial 
and we do not create a DTA account on the balance sheet, as doing so 
would unnecessarily complicate the adjustment to the market value 
change for tax effects. The tax effects are limited solely to loss 
carry-backs to recapture previous taxes paid.
    The stress test calculates a tax benefit from the unrealized loss 
that is included in regulatory capital. The amount included is based on 
the amount Farmer Mac can reasonably be assumed to realize immediately. 
The amount of the tax benefit included is based on the availability of 
tax-loss carry-backs to recapture any taxes paid in the past 2 years. 
The market value of equity loss resulting from stressful interest rate 
conditions is reduced by the amount of taxes actually paid in the 2 
previous years. The stress test also permits the unrealized loss to be 
used to offset any tax obligations, subject to Internal Revenue Service 
requirements, in future accounting cycles.
3. Application of Interest Rate Risk Through Changes in the Market 
Value of Equity
    To estimate the effects of the interest rate shocks (up and down 
scenarios) on Farmer Mac's equity position, the stress test computes 
the effective duration over each interest rate shock scenario using 
information supplied by Farmer Mac. The duration measure is then used 
as a proxy for market value effects under each interest rate scenario 
and market value changes are recorded as increases or decreases to 
equity on Farmer Mac's balance sheet.
    As a comment on the proposed rule, Farmer Mac suggested revising 
the proposed approach to reflect interest rate risk in the stress test. 
Farmer Mac objected to using market value changes, contending that the 
Act's definition of regulatory capital excludes any reference to market 
valuation concepts. Despite this definitional concern, Farmer Mac 
suggested modifying the proposed treatment of interest rate risk in the 
stress test by marking-to-market the balance sheet equity stated in 
accordance with GAAP before applying the changes in market value equity 
for the statutorily prescribed stressful change in interest rates. 
Farmer Mac stated the suggested revision would ensure the market value 
changes are consistently calculated against the market value of equity 
rather than incorrectly against the book value of equity (determined in 
accordance with GAAP).
    We developed the stress test so that its treatment of market value 
provides incentives for Farmer Mac to appropriately manage and control 
its exposure to movements in interest rates. The approach employed in 
the stress test uses effective duration measures supplied by Farmer 
Mac. We use these duration measures to determine a capital charge for 
interest rate risk. Our approach accepts that Farmer Mac's interest 
rate risk measurement accurately captures the dollar value of its 
interest rate risk exposure. This assumption represents a reasonable 
starting point for applying a stressful movement of interest rates used 
to determine Farmer Mac's regulatory capital requirement. Additionally, 
our approach eliminates the need to reconcile the differences between 
mark-to-market and book value financial statements that may vary 
through time for a multitude of reasons.
    We also believe our treatment of interest rate risk is consistent 
with the approach taken by several other financial regulators. The OTS, 
for example, requires savings associations to deduct a portion of the 
measured interest rate risk exposure from total capital to determine 
whether it meets its risk-based capital requirement.\24\ The starting 
point for determining total capital is a savings association's equity 
position determined in accordance with GAAP. The interest rate risk 
deduction to total capital is measured in accordance with the OTS Net 
Portfolio Value Model for a 200 basis point increase or decrease in 
market interest rates. The result of OTS's approach is a market value-
based interest rate risk deduction to total capital that was determined 
in accordance with GAAP.
---------------------------------------------------------------------------

    \24\ See 12 CFR 567.2 entitled, ``Minimum Regulatory Capital 
Requirement'' and 12 CFR 567.7, entitled, ``Interest Rate Risk 
Component.''
---------------------------------------------------------------------------

    Other banking regulators \25\ also apply a market risk component in 
the computation of regulatory capital ratios, again employing market 
value concepts.\26\ These regulators require certain institutions to 
convert excess market risk exposure to a risk-adjusted asset, resulting 
in a dollar-for-dollar holding of capital for the exposure. The net 
result of this treatment is the inclusion of market value-based 
interest rate risk in regulatory capital requirements calculated on 
financial statements prepared in accordance with GAAP.
---------------------------------------------------------------------------

    \25\ The other regulators are the OCC, the FRB, and the FDIC. 
These agencies acted jointly to add a market risk component to 
capital requirements for bank holding companies with large trading 
activities relative to their size.
    \26\ See 61 FR 47357-47378 (September 6, 1996).
---------------------------------------------------------------------------

    We also conclude that the treatment of interest rate risk is 
consistent with the Act's requirements and the definition of regulatory 
capital. The stress test implements the interest rate risk by 
considering its effect on various components that make up core capital, 
which in turn, make up regulatory capital.\27\ The Act specifies the 
range that rates can be shocked in the interest rate risk component of 
the stress test. The Act does not prescribe how we should implement the 
interest rate risk in the stress test in order to determine the impact 
of the components on core capital, and thus regulatory capital. We must 
use our discretion to determine a reasonable way to measure and 
implement the interest rate stress. We believe that the duration method 
is an appropriate and reasonable way to determine the impact of the 
interest rate stress on the components of core capital. Implementing 
this approach captures the effects of stressful interest rate movements 
on Farmer Mac's regulatory capital requirements in accordance with the 
Act.
---------------------------------------------------------------------------

    \27\ ``Regulatory capital'' is defined in section 8.31(5) of the 
Act as core capital plus an allowance for losses and guarantee 
claims (in accordance with GAAP). For the purposes of this 
definition, regulatory capital includes any allowance or reserve 
accounts that Farmer Mac maintains for losses on loans that are held 
in portfolio and for losses on securities it has guaranteed, 
particularly, reserves required by section 8.10 of the Act.
---------------------------------------------------------------------------

    Treasury also commented on the treatment of interest rate risk in 
the stress test. Treasury suggested that interest rate risk effects 
could be measured using a cashflow approach

[[Page 19061]]

where income and expenses are functions of the interest rate 
environment variable. Therefore, as rates moved in a stressful manner, 
Farmer Mac's net income performance would change.
    We originally considered a cashflow approach, but decided to follow 
an effective duration approach because it reduces the complexity of the 
stress test, thereby increasing efficiency in implementing the model. 
From a theoretical perspective, the effective duration-based approach 
uses market value estimates for interest rate shocks from Farmer Mac 
that already summarize cashflow effects. Therefore, there is no need to 
duplicate these effects in the cashflow component. As stated in the 
proposed rule, Farmer Mac may use its own cashflow generator for 
running the stress test as long as it is consistent with the final 
rule.
4. Operating Expenses Regression Equation Used in the Stress Test
    Farmer Mac commented that our proposed regression equation to 
represent operating expenses could be improved. Farmer Mac identified 
three problems with our proposed operating expense regression: (1) We 
should have included off-balance sheet assets in addition to on-balance 
sheet investments and program assets; (2) expenses are not a simple 
linear function of assets, but rather expenses increase at a decreasing 
rate as the volume of assets increases; and (3) we do not account for 
the difference in Farmer Mac's operating structure that resulted from a 
substantial statutory revision in 1996. Farmer Mac proposed the 
following regression equation:

Y =  + 1 ln(X) + 2D

Where Y is operating expenses, excluding provision for losses and tax 
expenses; ln(X) is the natural log of investments and Farmer Mac 
program assets held on- and off-balance sheet, and D is a dummy 
variable (1 represents pre-1996 and 0 represents post-1996).
    The regression is estimated using ordinary least squares, where 
() is the intercept, (1) is the 
coefficient for the natural log of the on-balance sheet program assets 
and investments, and off-balance sheet program assets, and 
(2) is the coefficient of the dummy variable.
    Based on Farmer Mac's comments, we considered several different 
operating expense equations, including Farmer Mac's proposed equation. 
We also evaluated whether loans, by themselves, would be a better 
indicator of operating expense growth. We found that loans, both on- 
and off-balance sheet, plus investments were relevant to operating 
expenses. We also found that including off-balance sheet assets is 
beneficial. We analyzed Farmer Mac's suggested equation and found that 
including the dummy variable and the log-linear approach are 
appropriate to use based on standard goodness-of-fit criteria. We also 
concluded that there is a reasonable conceptual basis for the loans and 
investments to be good predictors of operating expenses.
    We concur that the treatment of operating expenses should reflect 
the structural shift that occurred for Farmer Mac in 1996 due to 
statutory changes. Based on our analysis, we accept Farmer Mac's 
suggested regression equation as an appropriate treatment of operating 
expenses and we have revised Appendix A of subpart B accordingly.

C. Miscellaneous Technical Changes

    Farmer Mac made several technical comments on the stress test and 
Appendix A to subpart B. In addition, since developing the proposed 
risk-based capital stress test, we have conducted additional audits of 
the model specifications and Appendix A. Through this effort and the 
process of receiving public comments, we identified errors and 
inconsistencies that warranted technical changes in the proposed model 
specifications and Appendix A. As a result, we provide the following 
changes and clarifications.
1. Beta Distribution Used for the Seasoning Adjustment
    We noted an error in the implementation of the proposed beta 
distribution. In the proposed rule, we reported that the proposed beta 
distribution was estimated using a 14-year average loan life, while 
controlling for potentially longer lives. As implemented, using a 14-
year life effectively compresses the losses back into a shorter life 
than that used to estimate the proposed beta function parameters. Doing 
so resulted in a misstatement of the effects of loan seasoning in the 
calculation of expected age-adjusted lifetime losses. The misstatement 
occurs in the application of the shorter average loan life in the 
stress test compared to the effective interval of loan life used in 
estimating the beta distribution. We corrected for the scaling error in 
the final rule, which caused expected age-adjusted lifetime losses to 
increase compared to the proposed rule. As discussed below, we made an 
additional refinement in the estimation of the loan-seasoning function 
in response to comments received.
    Based on Farmer Mac's comments regarding the application of 
consistent underwriting screens to the estimation data, we again 
reviewed all components of the stress test to ensure we used 
appropriate data screens. This review revealed that we had estimated 
the proposed beta distribution parameters using different data screens 
than those used in the Study and in the estimation of the loss-
frequency equation. However, the use of different data screens was not 
a critical concern or issue in selecting the functional form. For the 
final model we re-estimated the beta distribution parameters to fully 
address Farmer Mac's comment about consistent underwriting screens.
    To re-estimate the beta distribution parameters, we used the same 
screened FCBT data that was used to estimate the loss-frequency model. 
The final re-estimated beta distribution parameters, assuming a 14-year 
average loan life, are p = 4.288 and q = 5.3185. The choice of data 
screens has an insignificant impact on the beta distribution 
properties.
2. Segregation of Off-Balance Sheet Instruments
    Under the proposed rule, we required that off-balance sheet items 
be classified either as off-balance sheet assets or as off-balance 
sheet liabilities. Farmer Mac commented that its internal valuation 
models do not differentiate between off-balance sheet assets and 
liabilities and requested that we clarify this issue. We have 
considered the treatment of off-balance sheet items and have decided to 
change the stress test to accommodate Farmer Mac's concern. While 
making this change, we made conforming changes to the effective 
duration calculations and calculation of the dollar amount of market 
value of equity change. The calculation now uses the base value of 
equity before any change in interest rate to determine the dollar 
amount of interest rate risk. This approach provides a consistency 
between the amount of interest rate risk measured by Farmer Mac and the 
amount applied in the regulatory capital calculation contained in the 
stress test. Because we eliminated the separate asset and liability 
duration calculations, we needed a new link to Farmer Mac's measured 
interest rate risk amount. This treatment of measured amounts of 
interest rate risk is similar to that used by other regulators in their 
regulatory capital requirements as discussed earlier in the section 
entitled, ``Application of MVE Impacts.''

[[Page 19062]]

3. Calculation of State-Level Loss Rates for Non-Standby Loans
    As discussed in section IV.A.8, we made a technical correction to 
the calculation of the loss rates for non-standby loans in the credit 
risk module. We now determine the loss rate for non-standby loans found 
on the ``Estimated Losses'' sheet of the credit loss module spreadsheet 
by dividing the estimated age-adjusted loan origination loss rates by 
the current principal balance outstanding. The change in methodology 
was needed to ensure consistent application of the correct dollar 
amount of estimated losses in the stress test. The revision also 
provides uniformity for the blending of non-standby and standby loss 
rates since each uses the same divisor.
    This revision caused the loss rates to increase slightly because we 
eliminated an error in the proposed rule that tended to slightly 
understate losses. At September 30, 2000, the overall blended loss rate 
determined by the credit loss module in the proposed rule was 2.0 
percent. In the final rule, the blended loss rate increased to 2.02 
percent, before making any of the other changes to the credit loss 
module as discussed throughout this preamble.
4. Other Technical Corrections
    Farmer Mac noted an inconsistency with the estimation of the logit 
model and application of the coefficient estimates to Farmer Mac's 
portfolio. We have changed the text in section 2.1 of Appendix A to 
subpart B to clarify the presentation.
    Farmer Mac identified a spreadsheet error in the Credit Module 
Excel Worksheet named, ``Transformed Data.'' We corrected the reference 
in the VLOOKUP command to the array of land value declines by State. 
The correction has no effect on the results of the stress test because 
there were no loans in the States that the model incorrectly referenced 
and the stressful land value change applied in the stress test is the 
same for all States.
    We also corrected an error in the spreadsheet relating to the 
computation of the 3-year maximum loss shares. Farmer Mac noted that 
when computing the 3-year losses for the column labeled 1992, the sum 
mistakenly included the column labeled, ``Total Losses.'' This 
corresponds to cohorts total lifetime losses so that the 3-year loss 
shares reported for 1992 are too high. This resulted in an erroneous 3-
year maximum loss share of 95.3 for the 1982 loan cohort. Correcting 
this error results in a 3-year total weighted average loss share of 
71.82 percent (versus 75.98 percent), and implies a year three stress 
period loss share of 11.66 percent (versus 15.82 percent), with an 
average loss share over the remaining 7 years of the stress period of 
4.03 percent (versus 3.43 percent).
    Farmer Mac noted that at June 30, 1999, the quarterly average 10-
year Constant Maturity Treasury yield was 5.10 rather than 5.54 as 
shown in the illustration in the section of the proposed preamble that 
includes the interest rate risk sensitivity discussion. We found that 
this error only occurred in the preamble illustration and the correct 
interest rate was used in both Appendix A to subpart B and the model. 
The error does not impact the illustration and it still shows the 
correct effects that different starting rates would have on the stress 
test. Thus, no change is necessary.
    In the preamble to the proposed rule, we noted that home mortgages 
from lenders in rural areas and small communities are eligible for sale 
to Farmer Mac for pooling and securitization. In that discussion, we 
incorrectly stated that the rural housing limit was $133,000. The 
current figure is $145,375, and is adjusted annually for inflation. 
This error had no effect on the model specifications.

D. Regulatory Capital Requirements Determined by the Final Stress Test

    The impact of the stress test depends on Farmer Mac's risk profile 
and starting capital position. High-risk loan assets or significant 
interest rate risk exposure will result in the stress test determining 
a higher regulatory capital requirement. Conversely, if Farmer Mac 
maintains a low risk profile in its loan portfolio or interest rate 
risk exposure, the stress test will determine a low capital 
requirement.
    Given Farmer Mac's September 30, 2000, financial position and risk 
profile, the stress test would not require Farmer Mac to increase its 
available regulatory capital. At this date, the stress test determined 
a regulatory capital requirement of $64.8 million. For illustration 
purposes only, this compares to Farmer Mac's core capital of $98.3 
million and a statutory minimum capital requirement of $93.6 million.
    We emphasize that the regulatory capital requirement is based on an 
evaluation of Farmer Mac's current financial condition and risk 
profile. If Farmer Mac accepts more risk as it grows into a mature 
business in the future, the risk-based capital requirement could exceed 
the statutory minimum capital standards. In such a situation, there are 
several options/alternatives available to Farmer Mac to meet its risk-
based capital requirement, including:
     Issuing additional stock;
     Increasing guarantee fees to build earnings and capital;
     Reducing credit risk by modifying loan underwriting 
standards or obtaining credit enhancements; or
     Mitigating interest rate risk through funding and hedging 
strategies.
    As addressed previously, commenters recommended numerous changes to 
the proposed stress test. In response to these comments, we modified 
the proposed stress test as described earlier. We compared the proposed 
and final rule results over the five most recent quarters. In all 
quarters, the final rule stress test produced higher estimated credit 
losses and thus a higher regulatory capital requirement. At September 
30, 2000, using Farmer Mac's financial position and risk profile, the 
proposed rule would have determined a regulatory capital level of $36.2 
million, while the final rule determined a regulatory capital level 
amount of $64.8 million. The final rule determines higher regulatory 
capital because of appropriate and consistent changes made to the 
stress test in response to comments about the loan size variable used 
in the loss-frequency equation, the loan-seasoning function, and the 
computation of loss rates in the credit loss component. With respect to 
the interest rate risk component, we changed the market value of equity 
calculation to provide consistent application based on comments 
received. This change had an insignificant impact on the level of 
interest rate risk factored into the final stress test compared to the 
proposed rule.

E. Appendix A to Subpart B of Part 650

    We have modified Appendix A to reflect the changes previously 
discussed. Farmer Mac requested more detailed information on every 
component of the stress test to help it understand and implement all 
details of the models and to effectively manage the stress test. 
Specifically, Farmer Mac asked for additional information on:
     The estimation and application of a power function for LTV 
in the lifetime default model;
     The estimation and application of the discount function 
applied to the maximum annualized decline in farmland values in the 
lifetime default model; and
     The derivation and application of a beta distribution to 
account for loan-seasoning adjustments.

[[Page 19063]]

    In response to Farmer Mac's request, we have included additional 
supporting information on each of these areas in the final Appendix A 
to subpart B. We anticipate that we will make additional revisions to 
Appendix A in the future, both to provide users more information and to 
clarify items. The most current version of Appendix A will be made 
available on our Web site (www.fca.gov) or by request.

V. Other Issues

A. Board of Directors and Reporting Issues

1. Business Planning Guidelines
    Farmer Mac's comment letter discussed various aspects of the 
proposed risk-based capital rule's requirements relative to business 
and capital planning and provided recommendations for revising the 
proposed rule's requirements on planning. Farmer Mac commented that, 
although it largely concurs with the proposed rule's requirements on 
business planning, it has several concerns with the proposed rule's 
requirements.
    First, Farmer Mac expressed a concern that the proposed rule 
requires the Farmer Mac board to adopt a business plan based on a 
calendar year cycle versus the board's specified planning year, which 
is currently June 1 through May 31. Although Farmer Mac's fiscal year 
coincides with the calendar year, Farmer Mac currently operates around 
the June 1 to May 31 business planning cycle. Because we do not see a 
need to disrupt Farmer Mac's current planning year cycle, we have 
modified the final rule to require Farmer Mac's board to adopt an 
annual business plan based on the plan year, as specified by its board.
    Second, Farmer Mac commented on the proposed rule's timeframe for 
its board's adoption of a business plan no later than 30 days after the 
beginning of the calendar year, stating it was inconsistent with the 
board's planning process and meeting schedule. Farmer Mac recommended 
the rule's language read that its board of directors be required to 
adopt an annual business plan within 75 days after the beginning of the 
planning year. Farmer Mac stated that it is the board's established 
practice to, at its June meeting, review business results for the just-
ended plan year (June-May), discuss new or revised objectives and 
strategies, and preliminarily approve the components of the business 
plan. Because the board only meets bimonthly, the board again reviews 
and adopts the plan at its August meeting.
    New directors are elected at Farmer Mac's annual meeting in June 
and begin their service with the Farmer Mac board that same day. Farmer 
Mac has structured its business plan development and approval process 
beginning at the June meeting, based on the desire to fully involve new 
directors in the planning process.
    We believe the full involvement of new directors in the planning 
process is highly beneficial. This process yields the best opportunity 
for meaningful business planning at Farmer Mac. The final rule requires 
that the Farmer Mac board annually adopt a business plan no later than 
65 days after the beginning of its planning year.
    Third, Farmer Mac commented on the proposed rule's requirement for 
the first year of its business plan to contain a detailed operating 
budget. Farmer Mac stated in its comment letter that budgets tend to 
impose rigid requirements for expenses that disregard the high 
variability of expense relative to income opportunities. In the past, 
Farmer Mac's board evaluated the merits of budgets versus financial 
forecasts and concluded that financial forecasts are more appropriate. 
Farmer Mac's comment letter indicated that financial forecasting allows 
the board to set targets for income and expenses that are reviewed 
during the year and adjusted as business and market conditions change. 
Farmer Mac requested that the final rule reflect the business judgment 
of its board and require an operating forecast instead of an operating 
budget in the first year of the plan.
    We concur that forecasts of income and expenses for the first year 
and the ensuing 2 years of the plan, based on clearly defined business 
assumptions, are appropriate for the board's oversight of Farmer Mac's 
performance. We are aware that the board reviews Farmer Mac's business 
performance at least quarterly and expect the board to adjust the 
business plan as necessary to meet Farmer Mac's business objectives. 
Accordingly, in the final rule we require forecasted income and expense 
and balance sheet statements for each year of the plan.
    Fourth, Farmer Mac commented that, with respect to business 
planning, the guidelines of the regulation should allow its board 
maximum flexibility and discretion in its business planning process and 
in exercising the business judgment expected of a board of a publicly 
traded corporation. In the rule, we set forth minimum standards for 
strategic business planning dictated by good business practices. These 
minimum standards allow the Farmer Mac board to retain a high degree of 
flexibility in its business plan; therefore, we are making no changes 
on this issue in the final rule.
    Lastly, Farmer Mac expressed a concern that the requirement that 
the business plan include detailed 3-year forecasts might expose Farmer 
Mac to potential securities law liability. The final rule's requirement 
for a 3-year business plan containing financial forecasts for each year 
of the plan is a tool for the Farmer Mac board to use in setting 
direction and overseeing the progress of Farmer Mac. As to exposing 
Farmer Mac to securities law liability, the business plan is for Farmer 
Mac's and FCA's internal use and not a public document. Thus, we have 
made no change to the final rule in response to this comment.
2. Reporting Requirements
    The proposed rule requires Farmer Mac to determine its risk-based 
capital requirements on a pro forma basis at any time that it expects 
to enter into any new business activity that could have a significant 
effect on capital. The proposed rule further requires that Farmer Mac 
report its pro forma determinations to OSMO at least 10-business days 
prior to implementation of the new business activity. Farmer Mac 
commented that a pro forma determination of risk-based capital should 
be made no later than 1 week ``after'' starting a new activity. Farmer 
Mac stated that we have adequate powers in rulemaking and enforcement 
to deal with any situation of noncompliance with the capital rule. 
Farmer Mac further stated that advance notice is similar to a prior 
approval process that we do not have authority to require.
    The rule does not create a prior approval process with respect to 
future Farmer Mac programs. The rule requires advance notice to us of 
the effect of new programs on capital to help ensure that any new 
program does not result in capital insufficiency. It is necessary and 
prudent to have in place a proactive process to review and evaluate 
future programs that impact capital prior to implementation. We believe 
that the use of pro forma determinations is an appropriate tool to 
evaluate the impact to capital of a pending program prior to its 
implementation. Further, we question implementation of a program 
without an internal pro forma analysis of the impact of such a program 
on the earnings and capital positions of Farmer Mac. We designed the 
stress test to be an efficient and effective tool for Farmer Mac to 
make such a pro forma analysis.
    We further believe that the reporting of a pro forma analysis to 
the OSMO

[[Page 19064]]

Director at least 10-business days prior to implementation is a 
reasonable timeframe that provides all parties ample time to discuss 
possible concerns and make adjustments where necessary and appropriate. 
A post review is inappropriate and could result in situations where 
programs might need to be modified after they have been established. 
Therefore, we continue to require a pro forma determination of the 
effect on risk-based capital requirements and reporting to the OSMO 
Director 10 days prior to implementation of a program that could have a 
significant effect on capital.

B. Examination and Oversight

    From a regulatory perspective, the ongoing nature of the risk-based 
capital stress test facilitates our understanding of how changes in 
Farmer Mac's business activities will affect its risk profile and 
resulting capital requirements. The effectiveness of the risk-based 
capital stress test may be affected by changes in Farmer Mac's 
operations, underwriting standards or products and services offered.
    Therefore, our ongoing monitoring and on-site examination will be 
integral in assessing Farmer Mac's capital adequacy. Our monitoring and 
examination program will help ensure that Farmer Mac appropriately 
implements the risk-based capital stress test. Together, the ongoing 
monitoring and examination by OSMO will enable us to provide effective 
regulatory oversight and ensure the adequacy of the regulatory capital 
standard set by the risk-based capital stress test.

C. Effective Date for Compliance With the Regulation

    For the 12-month period beginning on the effective date of this 
regulation, Farmer Mac must determine a risk-based capital level by 
implementing the risk-based capital stress test as described in 
Sec. 650.23 and appendix A of subpart B, and must report the results to 
us as described in Sec. 650.28. During this 12-month period, Farmer Mac 
will not be required to maintain capital at the risk-based capital 
level. Before and after the end of the 12-month period, Farmer Mac must 
continue to maintain its minimum capital level as prescribed in section 
8.33 of the Act. Beginning on the day following the 12-month period, 
Farmer Mac must comply with all provisions of this subpart.
    During the 1-year period following adoption of the final risk-based 
capital regulation, and on an ongoing basis thereafter, we will examine 
and verify Farmer Mac's implementation of the risk-based capital stress 
test. Subsequent to the end of the 12-month period, we will ensure 
compliance with the regulation, including the specifications identified 
in appendix A of part 650, subpart B.

D. Audit of the Risk-Based Capital Stress Test

    The final rule requires that Farmer Mac have its implementation of 
the risk-based capital stress test verified and audited once every 3 
years by an external independent party. The audit should ensure that 
the financial data used in the stress test are accurate and that the 
stress test is implemented in accordance with our regulations.

E. Availability to the Public

    As we noted in the beginning of this preamble, section 8.32(d) of 
the Act requires that the risk-based capital regulations contain 
specific information on the requirements, definitions, methods and 
parameters used in implementing the risk-based capital stress test in 
order to enable others to apply the test in a similar manner. We must 
also make available to the public any statistical model used to 
implement the risk-based capital stress test. Appendix A to part 650, 
subpart B, contains the specific information and instructions needed to 
run the risk-based capital stress test. An electronic version of the 
stress test is available to the public on our Web site at www.fca.gov.
    We note that because of the proprietary nature of specific, 
transaction-level loan and financial data used in the risk-based 
capital stress test, it is unlikely that results of the test will be 
fully reproducible by parties other than Farmer Mac and us. Other 
parties will, however, be able to approximate the test results on an 
aggregate basis using publicly available information.

F. Future Risk-Based Capital Requirements

    Farm Credit Bank commenters noted that the proposed regulation 
would not establish capital requirements applicable to any System 
institution other than Farmer Mac. Nevertheless, they expressed 
interest in this rulemaking proceeding for several reasons. First, the 
commenters acknowledged that, ``the development of the proposed stress 
test model to evaluate mortgage risk is new work in the agricultural 
mortgage sector.'' The commenters stated that risk-based capital 
measurement and management will become an increasingly important risk 
measurement tool for all System institutions. Second, the commenters 
stated that the final regulations established for Farmer Mac may serve 
as a precedent for the establishment of revised capital requirements 
for other System institutions at some point in the future.
    At the same time, the commenters noted that we should not be 
constrained in following these same requirements in evaluating the 
appropriate capital levels for other System institutions, as the 
thinking in this area continues to evolve and new approaches may 
emerge. Finally, the commenters urged us to ensure that the regulatory 
requirements for all System entities, including Farmer Mac, are fairly 
and finally determined on a comparable risk basis for the ultimate 
benefit and protection of America's farmers and ranchers.
    We appreciate the commenters' views on future capital requirements. 
However, we also recognize that the risk-based capital requirements for 
Farmer Mac are required to be established in response to title VIII of 
the Act. Title VIII establishes a credit and interest rate risk stress 
test. The stress test is designed to identify an extreme risk scenario 
and ensure that sufficient capital is maintained at all times to 
account for the most stressful risk scenario. In contrast, the 
structure of the pending Basel Accord revisions is directed toward 
establishing minimum and/or optimal capital requirements for financial 
institutions and is not based on one stressful scenario.
    Thus, although future development of any System risk-based capital 
requirements might employ risk-modeling techniques, such modeling would 
likely be based on a different set of assumptions and statistical 
methodologies rather than the stress test required in title VIII.

List of Subjects in 12 CFR Part 650

    Agriculture, Banks, banking, Conflicts of interest, Rural areas.


    For the reasons stated in the preamble, part 650 of chapter VI, 
title 12 of the Code of Federal Regulations is amended as follows:

PART 650--FEDERAL AGRICULTURAL MORTGAGE CORPORATION

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

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

    2. Add subpart B to read as follows:

[[Page 19065]]

Subpart B--Risk-Based Capital Requirements

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

Appendix A to Subpart B of Part 650--Risk-Based Capital Stress Test


Sec. 650.20  Definitions.

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


Sec. 650.21  General.

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


Sec. 650.22  Corporation board guidelines.

    (a) Your board of directors is responsible for ensuring that you 
maintain total capital at a level that is sufficient to ensure 
continued financial viability and provide for growth. In addition, your 
capital must be sufficient to meet statutory and regulatory 
requirements.
    (b) No later than 65 days after the beginning of Farmer Mac's 
planning year, your board of directors must adopt an operational and 
strategic business plan for at least the next 3 years. The plan must 
include:
    (1) A mission statement;
    (2) A review of the internal and external factors that are likely 
to affect you during the planning period;
    (3) Measurable goals and objectives;
    (4) Forecasted income, expense, and balance sheet statements for 
each year of the plan; and,
    (5) A capital adequacy plan.
    (c) The capital adequacy plan must include capital targets 
necessary to achieve the minimum, critical and risk-based capital 
standards specified by the Act and this subpart as well as your capital 
adequacy goals. The plan must address any projected dividends, equity 
retirements, or other action that may decrease your capital or its 
components for which minimum amounts are required by this subpart. You 
must specify in your plan the circumstances in which stock or equities 
may be retired. In addition to factors that must be considered in 
meeting the statutory and regulatory capital standards, your board of 
directors must also consider at least the following factors in 
developing the capital adequacy plan:
    (1) Capability of management;
    (2) Strategies and objectives in your business plan;
    (3) Quality of operating policies, procedures, and internal 
controls;
    (4) Quality and quantity of earnings;
    (5) Asset quality and the adequacy of the allowance for losses to 
absorb potential losses in your retained mortgage portfolio, securities 
guaranteed as to principal and interest, commitments to purchase 
mortgages or securities, and other program assets or obligations;
    (6) Sufficiency of liquidity and the quality of investments; and
    (7) Any other risk-oriented activities, such as funding and 
interest rate risks, contingent and off-balance sheet liabilities, or 
other conditions warranting additional capital.


Sec. 650.23  Risk-based capital stress test.

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

[[Page 19066]]

preceding 12 monthly 10-year CMT rates. Then increase and decrease the 
starting rate by:
    (i) 50 percent of the 12-month average if the average rate is less 
than 12 percent; or
    (ii) 600 basis points if the 12-month average rate is equal to or 
higher than 12 percent.
    (3) Following the first year of the stress period, interest rates 
remain at the new level for the remainder of the stress period.
    (4) You will apply the interest rate changes scenario as indicated 
in Appendix A to this subpart.
    (5) You may use other interest rate indices in addition to the 10-
year CMT subject to our concurrence, but in no event can your risk-
based capital level be less than that determined by using only the 10-
year CMT.
    (d) Cashflow generator. (1) You must adjust your financial 
statements based on the credit risk inputs and interest rate risk 
inputs described above to generate pro forma financial statements for 
each year of the 10-year stress test. The cashflow generator produces 
these financial statements. You may use the cashflow generator 
spreadsheet that is described in Appendix A to this subpart and 
available electronically at www.fca.gov. You may also use any reliable 
cashflow program that can develop or produce pro forma financial 
statements using generally accepted accounting principles and widely 
recognized financial modeling methods, subject to our concurrence. You 
may disaggregate financial data to any greater degree than that 
specified in Appendix A to this subpart, subject to our concurrence.
    (2) You must use model assumptions to generate financial statements 
over the 10-year stress period. The major assumption is that cashflows 
generated by the risk-based capital stress test are based on a steady 
state scenario. To implement a steady state scenario, when on- and off-
balance sheet assets and liabilities amortize or are paid down, you 
must replace them with similar assets and liabilities. Replace 
amortized assets from discontinued loan programs with current loan 
programs. In general, keep assets with small balances in constant 
proportions to key program assets.
    (3) You must simulate annual pro forma balance sheets and income 
statements in the risk-based capital stress test using Farmer Mac's 
starting position, the credit risk and interest rate risk components, 
resulting cashflow outputs, current operating strategies and policies, 
and other inputs as shown in Appendix A to this subpart and the 
electronic spreadsheet available at www.fca.gov.
    (e) Calculation of capital requirement. The calculations that you 
must use to solve for the starting regulatory capital amount are shown 
in appendix A to this subpart and in the electronic spreadsheet 
available at www.fca.gov.


Sec. 650.24  Risk-based capital level.

    The risk-based capital level is the sum of the following amounts:
    (a) Credit and interest rate risk. The amount of risk-based capital 
determined by the risk-based capital test under Sec. 650.23.
    (b) Management and operations risk. Thirty (30) percent of the 
amount of risk-based capital determined by the risk-based capital test 
in Sec. 650.23.


Sec. 650.25  Your responsibility for determining the risk-based capital 
level.

    (a) You must determine your risk-based capital level using the 
procedures in this subpart, appendix A to this subpart, and any other 
supplemental instructions provided by us. You will report your 
determination to us as prescribed in Sec. 650.28. At any time, however, 
we may determine your risk-based capital level using the procedures in 
Sec. 650.23 and appendix A to this subpart, and you must hold risk-
based capital in the amount we determine is appropriate.
    (b) You must at all times comply with the risk-based capital levels 
established by the risk-based capital stress test and must be able to 
determine your risk-based capital level at any time.
    (c) If at any time the risk-based capital level you determine is 
less than the minimum capital requirements set forth in section 8.33 of 
the Act, you must maintain the statutory minimum capital level.


Sec. 650.26  When you must determine the risk-based capital level.

    (a) You must determine your risk-based capital level at least 
quarterly, or whenever changing circumstances occur that have a 
significant effect on capital, such as exposure to a high volume of, or 
particularly severe, problem loans or a period of rapid growth.
    (b) In addition to the requirements of paragraph (a) of this 
section, we may require you to determine your risk-based capital level 
at any time.
    (c) If you anticipate entering into any new business activity that 
could have a significant effect on capital, you must determine a pro 
forma risk-based capital level, which must include the new business 
activity, and report this pro forma determination to the Director, 
Office of Secondary Market Oversight, at least 10-business days prior 
to implementation of the new business program.


Sec. 650.27  When to report the risk-based capital level.

    (a) You must file a risk-based capital report with us each time you 
determine your risk-based capital level as required by Sec. 650.26.
    (b) You must also report to us at once if you identify in the 
interim between quarterly or more frequent reports to us that you are 
not in compliance with the risk-based capital level required by 
Sec. 650.24.
    (c) If you make any changes to the data used to calculate your 
risk-based capital requirement that cause a material adjustment to the 
risk-based capital level you reported to us, you must file an amended 
risk-based capital report with us within 5-business days after the date 
of such changes;
    (d) You must submit your quarterly risk-based capital report for 
the last day of the preceding quarter not later than the last business 
day of April, July, October, and January of each year.


Sec. 650.28  How to report your risk-based capital determination.

    (a) Your risk-based capital report must contain at least the 
following information:
    (1) All data integral for determining the risk-based capital level, 
including any business policy decisions or other assumptions made in 
implementing the risk-based capital test;
    (2) Other information necessary to determine compliance with the 
procedures for determining risk-based capital as specified in Appendix 
A to this subpart; and,
    (3) Any other information we may require in written instructions to 
you.
    (b) You must submit each risk-based capital report in such format 
or medium, as we require.


Sec. 650.29  Failure to meet capital requirements.

    (a) Determination and notice. At any time, we may determine that 
you are not meeting your risk-based capital level calculated according 
to Sec. 650.23, your minimum capital requirements specified in section 
8.33 of the Act, or your critical capital requirements specified in 
section 8.34 of the Act. We will notify you in writing of this fact and 
the date by which you should be in compliance (if applicable).
    (b) Submission of capital restoration plan. Our determination that 
you are not meeting your required capital levels may require you to 
develop and submit to us, within a specified time period, an

[[Page 19067]]

acceptable plan to reach the appropriate capital level(s) by the date 
required.


Sec. 650.30  Effective date for compliance with regulation.

    For the 12-month period beginning on the effective date of this 
subpart, you must determine a risk-based capital level by implementing 
the risk-based capital stress test as described in Sec. 650.23 and 
Appendix A to this subpart, and you must report the results to us as 
described in Sec. 650.28. During this 12-month period, you will not be 
required to maintain capital at the risk-based capital level, but you 
must maintain your minimum capital level as prescribed in section 8.33 
of the Act. Beginning on the day following the 12-month period, you 
must comply with all provisions of this subpart.


Sec. 650.31  Audit of the risk-based capital stress test.

    You must have a qualified, independent external auditor review your 
implementation of the risk-based capital stress test every 3 years and 
submit a copy of the auditor's opinion to us.

Appendix A--Subpart B of Part 650--Risk-Based Capital Stress Test

1.0  Introduction.
2.0  Credit Risk.
2.1  Loss-Frequency and Loss-Severity Models.
2.2  Loan-Seasoning Adjustment.
2.3  Example Calculation of Dollar Loss on One Loan.
2.4  Treatment of Long-term Standby Purchase Commitments.
2.5  Calculation of Loss Rates for Use in the Stress Test.
3.0  Interest Rate Risk.
3.1  Process for Calculating the Interest Rate Movement.
4.0  Elements Used in Generating Cashflows.
4.1  Data Inputs.
4.2  Assumptions and Relationships.
4.3  Risk Measures.
4.4  Loan and Cashflow Accounts.
4.5  Income Statements.
4.6  Balance Sheets.
4.7  Capital.
5.0  Capital Calculation.
5.1  Method of Calculation.

1.0  Introduction

    a. Appendix A provides details about the risk-based capital 
stress test (stress test) for Farmer Mac. The stress test calculates 
the risk-based capital level required by statute under stipulated 
conditions of credit risk and interest rate risk. The stress test 
uses loan-level data from Farmer Mac's agricultural mortgage 
portfolio, as well as quarterly Call Report and related information 
to generate pro forma financial statements and calculate a risk-
based capital requirement. The stress test also uses historic 
agricultural real estate mortgage performance data, relevant 
economic variables, and other inputs in its calculations of Farmer 
Mac's capital needs over a 10-year period.
    b. Appendix A establishes the requirements for all components of 
the stress test. The key components of the stress test are: 
specifications of credit risk, interest rate risk, the cashflow 
generator, and the capital calculation. Linkages among the 
components ensure that the measures of credit and interest rate risk 
pass into the cashflow generator. The linkages also transfer 
cashflows through the financial statements to represent values of 
assets, liabilities, and equity capital. The 10-year projection is 
designed to reflect a steady state in the scope and composition of 
Farmer Mac's assets.

2.0  Credit Risk

    Loan loss rates are determined by applying loss-frequency and 
loss-severity equations to Farmer Mac loan-level data. From these 
equations, you must calculate loan losses under stressful economic 
conditions assuming Farmer Mac's portfolio remains at a ``steady 
state.'' Steady state assumes the underlying characteristics and 
risks of Farmer Mac's portfolio remain constant over the 10 years of 
the stress test. Loss rates are computed from estimated dollar 
losses for use in the stress test. The loan volume subject to loss 
throughout the stress test is then multiplied by the loss rate. 
Lastly, the stress test allocates losses to each of the 10 years 
assuming a time pattern for loss occurrence as discussed in section 
4.3, ``Risk Measures.''

2.1  Loss-Frequency and Loss-Severity Models

    a. Credit risks are modeled in the stress test using historical 
time series loan-level data to measure the frequency and severity of 
losses on agricultural mortgage loans. The model relates loss 
frequency and severity to loan-level characteristics and economic 
conditions through appropriately specified regression equations to 
account explicitly for the effects of these characteristics on loan 
losses. Loan losses for Farmer Mac are estimated from the resulting 
loss-frequency and loss-severity equations by substituting the 
respective values of Farmer Mac's loan-level data, and applying 
stressful economic inputs.
    b. The loss-frequency and loss-severity equations were estimated 
from historical agricultural real estate mortgage loan data from the 
Farm Credit Bank of Texas (FCBT). Due to Farmer Mac's relatively 
short history, its own loan-level data are insufficiently developed 
for use in estimating default frequency and loss-severity equations. 
In the future, however, expansions in both the scope and historic 
length of Farmer Mac's lending operations may support the use of its 
data in estimating the relationships.
    c. To estimate the equations, the data used included FCBT loans, 
which satisfied three of the four underwriting standards Farmer Mac 
currently uses (estimation data). The four standards specify: (1) 
The debt-to-assets ratio (D/A) must be less than 0.50, (2) the loan-
to-value ratio (LTV) must be less than 0.70, (3) the debt-service-
coverage ratio (DSCR) must exceed 1.25, (4) and the current ratio 
(current assets divided by current liabilities) must exceed 1.0. 
Furthermore, the D/A and LTV ratios were restricted to be less than 
or equal to 0.85.
    d. Several limitations in the FCBT loan-level data affect 
construction of the loss-frequency equation. The data contained 
loans that were originated between 1979 and 1992, but there were 
virtually no losses during the early years of the sample period. As 
a result, losses attributable to specific loans are only available 
from 1986 through 1992. In addition, no prepayment information was 
available in the data.
    e. The FCBT data used for estimation also included as performing 
loans, those loans that were re-amortized, paid in full, or merged 
with a new loan. Including these loans may lead to an understatement 
of loss-frequency probabilities if some of the re-amortized, paid, 
or merged loans experience default or incur losses. In contrast, 
when the loans that are re-amortized, paid in full, or merged are 
excluded from the analysis, the loss-frequency rates are overstated 
if a higher proportion of loans that are re-amortized, paid in full, 
or combined (merged) into a new loan are non-default loans compared 
to live loans.\1\
---------------------------------------------------------------------------

    \1\ Excluding loans with defaults, 11,527 loans were active and 
7,515 loans were paid in full, re-amortized or merged as of 1992. A 
t-test\2\ of the differences in the means for the group of defaulted 
loans and active loans indicated that active loans had significantly 
higher D/A and LTV ratios, and lower current ratios than defaulted 
loans where loss occurred. These results indicate that, on average, 
active loans have potentially higher risk than loans that were re-
amortized, paid in full, or merged.
---------------------------------------------------------------------------

    f. The structure of the historical FCBT data supports estimation 
of loss frequency based on origination information and economic 
conditions. Under an origination year approach, each observation is 
used only once in estimating loan default. The underwriting 
variables at origination and economic factors occurring over the 
life of the loan are then used to estimate loan-loss frequency.
    g. The final loss-frequency equation is based on origination 
year data and represents a lifetime loss-frequency model. The final 
equation for loss frequency is:

p = 1/(1+exp(-(BX))

Where:

BX = (-12.62738) + 1.91259  X1 + (-0.33830) 
 X2 / (1 + 0.0413299)\Periods\ + (-0.19596) 
 X3 + 4.55390  (1- exp((-0.00538178) 
 X4) + 2.49482  X5

Where:

     p is the probability that a loan defaults and has 
positive losses (Pr (Y=1|x));
     X1 is the LTV ratio at loan origination 
raised to the power 5.3914596; \2\
---------------------------------------------------------------------------

    \2\ Loss probability is likely to be more sensitive to changes 
in LTV at higher values of LTV. The power function provides a 
continuous relationship between LTV and defaults.
---------------------------------------------------------------------------

     X2 is the largest annual percentage decline 
in FCBT farmland values during the life of the loan dampened with a 
factor of 0.0413299 per year; \3\
---------------------------------------------------------------------------

    \3\ The dampening function reflects the declining effect that 
the maximum land value decline has on the probability of default 
when it occurs later in a loan's life.
---------------------------------------------------------------------------

     X3 is the DSCR at loan origination;
     X4 is 1 minus the exponential of the product 
of negative 0.00538178 and the

[[Page 19068]]

original loan balance in 1997 dollars expressed in thousands; and
     X5 is the D/A ratio at loan origination.
    h. The estimated logit coefficients and p-values are: \4\
---------------------------------------------------------------------------

    \4\ The nonlinear parameters for the variable transformations 
were simultaneously estimated using SAS version 8e NLIN procedure. 
The NLIN procedure produces estimates of the parameters of a 
nonlinear transformation for LTV, dampening factor, and loan-size 
variables. To implement the NLIN procedure, the loss-frequency 
equation and its variables are declared and initial parameter values 
supplied. The NLIN procedure is an iterative process that uses the 
initial parameter values as the starting values for the first 
iteration and continues to iterate until acceptable parameters are 
solved. The initial values for the power function and dampening 
function are based on the proposed rule. The procedure for the 
initial values for the size variable parameter is provided in an 
Excel spreadsheet posted at www.fca.gov.
    The Gauss-Newton method is the selected iterative solving 
process. As described in the preamble, the loss-frequency function 
for the nonlinear model is the negative of the log-likelihood 
function, thus producing maximum likelihood estimates. In order to 
obtain statistical properties for the loss-frequency equation and 
verify the logistic coefficients, the estimates for the nonlinear 
transformations are applied to the FCBT data and the loss-frequency 
model is re-estimated using the SAS Logistic procedure. The SAS 
procedures, output reports and Excel spreadsheet used to estimate 
the parameters of the loss-frequency equation are located on the Web 
site www.fca.gov.

------------------------------------------------------------------------
                                       Coefficients         p-value
------------------------------------------------------------------------
Intercept..........................        -12.62738  0.0001
X1: LTV variable...................          1.91259  0.0001
X2: Max land value decline variable          0.33830  0.0001
X3: DSCR...........................         -0.19596  0.0002
X4: Loan size variable.............          4.55390  0.0001
X5: D/A ratio......................          2.49482  0.0000
------------------------------------------------------------------------

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


Hosmer and Lemeshow goodness-of-fit p-value..  0.1718
Max-rescaled R\2\............................  0.2015
Concordant...................................  85.2%
Disconcordant................................  12.0%
Tied.........................................  2.8%
 

    j. These variables have logical relationships to the incidence 
of loan default and loss, as evidenced by the findings of numerous 
credit-scoring studies in agricultural finance.\5\ Each of the 
variable coefficients has directional relationships that 
appropriately capture credit risk from underwriting variables and, 
therefore, the incidence of loan-loss frequency. The frequency of 
loan loss was found to differ significantly across all of the loan 
characteristics and lending conditions. Farmland values represent an 
appropriate variable for capturing the effects of exogenous economic 
factors. It is commonly accepted that farmland values at any point 
in time reflect the discounted present value of expected returns to 
the land.\6\ Thus, changes in land values, as expressed in the loss-
frequency equation, represent the combined effects of the level and 
growth rates of farm income, interest rates, and inflationary 
expectations--each of which is accounted for in the discounted, 
present value process.
---------------------------------------------------------------------------

    \5\ Splett, N.S., P. J. Barry, B. Dixon, and P. Ellinger. ``A 
Joint Experience and Statistical Approach to Credit Scoring,'' 
Agricultural Finance Review, 54(1994):39-54.
    \6\ Barry, P. J., P. N. Ellinger, J. A. Hopkin, and C. B. Baker. 
Financial Management in Agriculture, 5th ed., Interstate Publishers, 
1995.
---------------------------------------------------------------------------

    k. When applying the equation to Farmer Mac's portfolio, you 
must get the input values for X1, X3, 
X4, and X5 for each loan in Farmer Mac's 
portfolio on the date at which the stress test is conducted. For the 
variable X2, the stressful input value from the benchmark 
loss experience is -23.52 percent. You must apply this input to all 
Farmer Mac loans subject to loss to calculate loss frequency under 
stressful economic conditions.\7\ The maximum land value decline 
from the benchmark loss experience is the simple average of annual 
land value changes for Iowa, Illinois, and Minnesota for the years 
1984 and 1985.\8\
---------------------------------------------------------------------------

    \7\ On- and off-balance sheet Farmer Mac I agricultural mortgage 
program assets booked after the 1996 Act amendments are subject to 
the loss calculation.
    \8\ While the worst-case losses, based on origination year, 
occurred during 1983 and 1984, this benchmark was determined using 
annual land value changes that occurred 2 years later.
---------------------------------------------------------------------------

    l. Forecasting with data outside the range of the estimation 
data requires special treatment for implementation. While the 
estimation data embody Farmer Mac values for various loan 
characteristics, the maximum farmland price decline experienced in 
Texas was -16.69 percent, a value below the benchmark experience of 
-23.52 percent. To control for this effect, you must apply a 
procedure that restricts the slope of all the independent variables 
to that observed at the maximum land value decline observed in the 
estimation data. Essentially, you must approximate the slope of the 
loss-frequency equation at the point -16.69 percent in order to 
adjust the probability of loan default and loss occurrence for data 
beyond the range in the estimating data. The adjustment procedure is 
shown in step 4 of section 2.3 entitled, ``Example Calculation of 
Dollar Loss on One Loan.''
    m. Loss severity was not found to vary systematically and was 
considered constant across the tested loan characteristics and 
lending conditions. Thus, the simple weighted average by loss volume 
of 20.9 percent is used in the stress test.\9\ You must multiply 
loss severity with the probability estimate computed from the loss-
frequency equation to determine the loss rate for a loan.
---------------------------------------------------------------------------

    \9\ We calculated the weighted-average loss severity from the 
estimation data.
---------------------------------------------------------------------------

    n. Using original loan balance results in estimated 
probabilities of loss frequency over the entire life of a loan. To 
account for loan seasoning, you must reduce the loan-loss exposure 
by the cumulative probability of loss already experienced by each 
loan as discussed in section 2.2 entitled, ``Loan-Seasoning 
Adjustment.'' This subtraction is based on loan age and reduces the 
loss estimated by the loss-frequency and loss-severity equations. 
The result is an age-adjusted lifetime dollar loss that can be used 
in subsequent calculations of loss rates as discussed in section 
2.5, ``Calculation of Loss Rates for Use in the Stress Test.''

2.2  Loan-Seasoning Adjustment

    a. You must use the seasoning distribution to adjust each Farmer 
Mac loan for the cumulative loss exposure already experienced based 
on age. The effect of seasoning on the probability of loss is 
represented as a beta distribution. The distribution is based on the 
estimation data used to determine the loss-frequency equation. Using 
the estimation data, the cumulative total loss fractions are used to 
calculate the cumulative proportion of losses at each point in time. 
The two parameters of the beta distribution are then solved using a 
least squares error distance function, implemented with Microsoft 
Excel's solver utility. The spreadsheet for calculating the beta 
distribution is available on our Web site, www.fca.gov, or upon 
request.
    b. The Excel solver utility uses a least squares framework 
rather than a direct maximum likelihood (product of probabilities) 
estimator. As a result, the Excel solver utility produces beta 
distribution parameters that are immaterially different from those 
estimated directly using a maximum likelihood estimator. The 
estimation of the beta distribution parameters is based on an 
average life of 14 years for agricultural mortgages. If the average 
life of agricultural mortgages in Farmer Mac's portfolio over time 
differs significantly from 14 years, we may re-estimate the beta 
distribution parameters.
    c. The estimated seasoning beta distribution parameters for a 
14-year average loan life that must be used are p = 4.288 and

[[Page 19069]]

q = 5.3185.\10\ How the loan-seasoning distribution is used is shown 
in Step 7 of section 2.3, ``Example Calculation of Dollar Loss on 
One Loan.''
---------------------------------------------------------------------------

    \10\ We estimated the loan-seasoning distribution from portfolio 
aggregate charge-off rates from the estimation data. To do so, we 
arrayed all defaulting loans where loss occurred according to the 
time from origination to default. Then, a beta distribution, 
(p, q), was fit to the estimation data scaled to the 
maximum time a loan survived (14 years).
---------------------------------------------------------------------------

2.3  Example Calculation of Dollar Loss on One Loan

    Here is an example of the calculation of the dollar losses for 
an individual loan with the following characteristics and input 
values: \11\
---------------------------------------------------------------------------

    \11\ In the examples presented we rounded the numbers, but the 
example calculation are based on a larger number of significant 
digits. The stress test uses additional digits carried at the 
default precision of the software.

Loan Origination Year.....................................          1996
Loan Origination Balance..................................    $1,250,000
LTV at Origination........................................           0.5
D/A at Origination........................................           0.5
DSCR at Origination.......................................        1.3984
Maximum Percentage Land Price Decline (MAX)...............        -23.52
 


    Step 1: Convert 1996 Origination Value to 1997 dollar value 
(LOAN) based on the consumer price index and transform as follows:

$1,278,500 = $1,250,000  1.0228
0.998972 = 1 - exp((-.00538178)  $1,278,500 / 1000)

    Step 2: Calculate the default probabilities using -16.64 percent 
and -16.74 percent land value declines as follows: \12\
---------------------------------------------------------------------------

    \12\ This process facilitates the approximation of slope needed 
to adjust the loss probabilities for land value declines greater 
than observed in the estimation data.
---------------------------------------------------------------------------

Where,

Z1 = (-12.62738) + 1.91259  
LTV5.3914596 - 0.33830  (-16.6439443) - 0.19596 
 DSCR + 4.55390  0.998972 + 2.49482  
DA = (-1.428509)

Default Loss Frequency @ (-16.64%) = 
1 / 1 + exp-(-1.428509) = 0.19333111

And

Z1 = (-12.62738) + 1.91259  
LTV5.3914596 - 0.33830  (-16.7439443) - 0.19596 
 DSCR + 4.55390  0.998972 + 2.49482  
DA = (-1.394679)

Loss Frequency Probability @ (-16.74%) = 1 / 1 + 
exp-(-1.394679) = 0.19866189

    Step 3: Calculate the slope adjustment. You must calculate slope 
by subtracting the difference between ``Loss-Frequency Probability @ 
-16.64 percent'' and ``Loss-Frequency Probability @ -16.74 percent'' 
and dividing by -0.1 (the difference between -16.64 percent and 
-16.74 percent) as follows:

0.05330776 = (0.19333111 - 0.19866189) / -0.1

    Step 4: Make the linear adjustment. You make the adjustment by 
increasing the loss-frequency probability where the dampened 
stressed farmland value input is less than -16.69 percent to reflect 
the stressed farmland value input, appropriately discounted. As 
discussed previously, the stressed land value input is discounted to 
reflect the declining effect that the maximum land value decline has 
on the probability of default when it occurs later in a loan's 
life.\13\ The linear adjustment is the difference between -16.69 
percent land value decline and the adjusted stressed maximum land 
value decline input of -23.52 multiplied by the slope estimated in 
Step 3 as follows:

    \13\ The dampened period is the number of years from the 
beginning of the origination year to the current year (i.e., January 
1, 1996, to January 1, 2000, is 4 years).
---------------------------------------------------------------------------

Loss Frequency -16.69 percent =

Z1 = (-12.62738) + (1.91259)(LTV5.3914596) - 
(0.33830) (-16.6939443) - (0.19596) (DSCR) + (4.55390)(0.998972) + 
(2.49482) (DA) = -1.411594

And

1 / 1 + exp-(-1.411594) = 0.19598279

Dampened Maximum Land Price Decline = (-20.00248544) = 
(-23.52)(1.0413299)-4
Slope Adjustment = 0.17637092 = 0.053312247  (-16.6939443 
- (-20.00248544))

Loan Default Probability = 0.37235371 = 0.19598279 + 0.17637092

    Step 5: Multiply loan default probability times the average 
severity of 0.209 as follows:

0.077821926 = 0.37235371  0.209

    Step 6: Multiply the loss rate times the origination loan 
balance as follows:

$97,277 = $1,250,000  0.077821926

    Step 7: Adjust the origination based dollar losses for 4 years 
of loan seasoning as follows:

$81,987 = $97,277 - $97,277  (0.157178762) \14\
---------------------------------------------------------------------------

    \14\ The age adjustment of 0.157178762 is determined from the 
beta distribution for a 4-year old loan.
---------------------------------------------------------------------------

2.4  Treatment of Long-Term Standby Purchase Commitments

    The loss-frequency equation cannot be directly used to compute 
the loss exposure on loans covered by a long-term standby purchase 
commitment (standbys) because complete underwriting standards for 
these loans are unavailable. Instead, the initial loss rate applied 
to each standby loan is the respective state-level average loss rate 
unadjusted for loan seasoning. You must calculate the state-level 
loss rates from non-standby loans as total dollar loan losses before 
the loan-seasoning adjustment divided by total origination loan 
balances. Then, you must multiply the origination loan balance of 
each standby loan by the appropriate loss rate to calculate 
estimated dollar losses. You must then adjust the resulting standby 
loan-level dollar losses adjusted for loan seasoning as was done for 
non-standby loans. For example, consider a $1,000,000 standby loan 
originated in Idaho in 1990. And, suppose the unadjusted loss rate 
for Idaho is 3 percent. The loss for this loan is:

($1,000,000  0.03) = $30,000.

The loan is 7 years old, thus the seasoning adjustment is 
0.635989125. The estimated age-adjusted losses for the standby loan 
are:

$10,920 = ($30,000)(1 - 0.635989125)

2.5  Calculation of Loss Rates for Use in the Stress Test

    a. You must compute the loss rates by state (based on Farmer 
Mac's loan portfolio distribution) after you calculate dollar loan 
losses for each loan subject to loss in Farmer Mac's portfolio. The 
estimated lifetime losses adjusted for loan seasoning for non-
standby loans are computed as total dollar loan losses adjusted for 
loan seasoning divided by total scheduled current loan balances for 
each state. Similarly, you must calculate the estimated lifetime 
losses and adjust for loan seasoning for standby loans. This 
calculation is the total dollar loan losses adjusted for loan 
seasoning divided by total scheduled current loan balances for each 
state. You must then blend the resulting state-level loss rates for 
non-standby and standby loans by blending the average loss rate for 
each state weighted by volume. The state loss rates estimated for 
Farmer Mac's loan portfolio are calculated in the spreadsheet, 
``Credit Loss Module.XLS.'' This spreadsheet is available for 
download on our Web site, www.fca.gov, or will be provided upon 
request. The blended loss rates for each state are copied from the 
``Credit Loss Module'' to the stress test spreadsheet for 
determining Farmer Mac's regulatory capital requirement.
    b. The stress test use of the blended loss rates is further 
discussed in section 4.3, ``Risk Measures.''

3.0  Interest Rate Risk

    The stress test explicitly accounts for Farmer Mac's 
vulnerability to interest rate risk from the movement in interest 
rates specified in the statute. The stress test considers Farmer 
Mac's interest rate risk position through the current structure of 
its balance sheet, reported interest rate risk shock-test 
results,\15\ and other financial activities. The stress test 
calculates the effect of interest rate risk exposure through market 
value changes of interest-bearing assets, liabilities, and off-
balance sheet transactions, and thereby the effects to equity 
capital. The stress test also captures this exposure through the 
cashflows on rate-sensitive assets and liabilities. We discuss how 
to calculate the dollar impact of interest rate risk in section 4.6, 
``Balance Sheets.''
---------------------------------------------------------------------------

    \15\ See paragraph c of section 4.1 entitled, ``Data Inputs'' 
for a description of the interest rate risk shock-reporting 
requirement.
---------------------------------------------------------------------------

3.1  Process for Calculating the Interest Rate Movement

    a. The stress test uses the 10-year Constant Maturity Treasury 
(10-year CMT) released by the Federal Reserve in HR. 15, ``Selected 
Interest Rates.'' The stress test uses the 10-year CMT to generate 
earnings yields on assets, expense rates on liabilities, and changes 
in the market value of assets and liabilities. For stress test 
purposes, the starting rate for the 10-year CMT is the 3-month 
average of the most recent monthly rate series published by the 
Federal Reserve. The 3-month average is calculated by summing the 
latest monthly series of the 10-year CMT and dividing by three. For

[[Page 19070]]

instance, you would calculate the initial rate on June 30, 1999, as:

------------------------------------------------------------------------
                                                            10-year CMT
                        Month end                         monthly series
------------------------------------------------------------------------
04/1999.................................................            5.18
05/1999.................................................            5.54
06/1999.................................................            5.90
                                                         ---------------
Average.................................................            5.54
------------------------------------------------------------------------

    b. The amount by which the stress test shocks the initial rate 
up and down is determined by calculating the 12-month average of the 
10-year CMT monthly series. If the resulting average is less than 12 
percent, the stress test shocks the initial rate by an amount 
determined by multiplying the 12-month average rate by 50 percent. 
However, if the average is greater than or equal to 12 percent, the 
stress test shocks the initial rate by 600 basis points. For 
example, determine the amount by which to increase and decrease the 
initial rate for June 30, 1999, as follows:

------------------------------------------------------------------------
                                                            10-year CMT
                        Month end                         monthly series
------------------------------------------------------------------------
07/1998.................................................            5.46
08/1998.................................................            5.34
09/1998.................................................            4.81
10/1998.................................................            4.53
11/1998.................................................            4.83
12/1998.................................................            4.65
01/1999.................................................            4.72
02/1999.................................................            5.00
03/1999.................................................            5.23
04/1999.................................................            5.18
05/1999.................................................            5.54
06/1999.................................................            5.90
                                                         ---------------
12-Month Average........................................            5.10
------------------------------------------------------------------------


Calculation of Shock Amount:
12-Month Average Less than 12%................  Yes
12-Month Average..............................  5.10
Multiply the 12-Month Average by..............  50%
Shock in basis points equals..................  255
 


    c. You must run the stress test for two separate changes in 
interest rates: (i) An immediate increase in the initial rate by the 
shock amount; and (ii) immediate decrease in the initial rate by the 
shock amount. The stress test then holds the changed interest rate 
constant for the remainder of the 10-year stress period. For 
example, at June 30, 1999, the stress test would be run for an 
immediate and sustained (for 10 years) upward movement in interest 
rates to 8.09 percent (5.54 percent plus 255 basis points) and also 
for an immediate and sustained (for 10 years) downward movement in 
interest rates to 2.99 percent (5.54 percent minus 255 basis 
points). The movement in interest rates that results in the greatest 
need for capital is then used to determine Farmer Mac's risk-based 
capital requirement.

4.0  Elements Used in Generating Cashflows

    a. This section describes the elements that are required for 
implementation of the stress test and assessment of Farmer Mac 
capital performance through time. An Excel spreadsheet named FAMC 
RBCST, available at www.fca.gov, contains the stress test, including 
the cashflow generator. The spreadsheet contains the following seven 
worksheets:
    (1) Data Input;
    (2) Assumptions and Relationships;
    (3) Risk Measures (credit risk and interest rate risk);
    (4) Loan and Cashflow Accounts;
    (5) Income Statements;
    (6) Balance Sheets; and
    (7) Capital.
    b. Each of the components is described in further detail in 
sections 4.1 through 4.7 of this appendix with references where 
appropriate to the specific worksheets within the Excel spreadsheet. 
The stress test may be generally described as a set of linked 
financial statements that evolve over a period of 10 years using 
generally accepted accounting conventions and specified sets of 
stressed inputs. The stress test uses the initial financial 
condition of Farmer Mac, including earnings and funding 
relationships, and the credit and interest rate stressed inputs to 
calculate Farmer Mac's capital performance through time. The stress 
test then subjects the initial financial conditions to the first 
period set of credit and interest rate risk stresses, generates 
cashflows by asset and liability category, performs necessary 
accounting postings into relevant accounts, and generates an income 
statement associated with the first interval of time. The stress 
test then uses the income statement to update the balance sheet for 
the end of period 1 (beginning of period 2). All necessary capital 
calculations for that point in time are then performed.
    c. The beginning of the period 2 balance sheet then serves as 
the departure point for the second income cycle. The second period's 
cashflows and resulting income statement are generated in similar 
fashion as the first period's except all inputs (i.e., the periodic 
loan losses, portfolio balance by category, and liability balances) 
are updated appropriately to reflect conditions at that point in 
time. The process evolves forward for a period of 10 years with each 
pair of balance sheets linked by an intervening set of cashflow and 
income statements. In this and the following sections, additional 
details are provided about the specification of the income-
generating model to be used by Farmer Mac in calculating the risk-
based capital requirement.

4.1  Data Inputs

    The stress test requires the initial financial statement 
conditions and income generating relationships for Farmer Mac. The 
worksheet named ``Data Inputs'' contains the complete data inputs 
and the data form used in the stress test. The stress test uses 
these data and various assumptions to calculate pro forma financial 
statements. For stress test purposes, Farmer Mac is required to 
supply:
    a. Call Report Schedules RC: Balance Sheet and RI: Income 
Statement. These schedules form the starting financial position for 
the stress test. In addition, the stress test calculates basic 
financial relationships and assumptions used in generating pro forma 
annual financial statements over the 10-year stress period. 
Financial relationships and assumptions are in section 4.2, 
``Assumptions and Relationships.''
    b. Cashflow Data for Asset and Liability Account Categories. The 
necessary cashflow data for the spreadsheet-based stress test are 
book value, weighted average yield, weighted average maturity, 
conditional prepayment rate, weighted average amortization, and 
weighted average guarantee fees. The spreadsheet uses this cashflow 
information to generate starting and ending account balances, 
interest earnings, guarantee fees, and interest expense. Each asset 
and liability account category identified in this data requirement 
is discussed in section 4.2, ``Assumptions and Relationships.''
    c. Interest Rate Risk Measurement Results. The stress test uses 
the results from Farmer Mac's interest rate risk model to represent 
changes in the market value of assets, liabilities, and off-balance 
sheet positions during upward and downward instantaneous shocks in 
interest rates of 300, 250, 200, 150, and 100 basis points. The 
stress test uses these data to calculate a schedule of estimated 
effective durations representing the market value effects from a 
change in interest rates. The stress test uses a linear 
interpolation of the duration schedule to relate a change in 
interest rates to a change in the market value of equity. This 
calculation is described in paragraph 4.4 entitled, ``Loan and 
Cashflow Accounts,'' and is illustrated in the referenced worksheet 
of the stress test.
    d. Loan-Level Data for all Farmer Mac I Program Assets.
    (1) The stress test requires loan-level data for all Farmer Mac 
I program assets to determine lifetime age-adjusted loss rates. The 
specific loan data fields required for running the credit risk 
component are:

------------------------------------------------------------------------
    All other Farmer Mac I
        program loans                Long-term standby commitments
------------------------------------------------------------------------
Loan Number..................  Loan Number.
Ending Scheduled Balance.....  Current Month Actual Balance.
Group........................  Group.
Pre/Post Act.................  Pre/Post Act.
Property State...............  Property State.
Product Type.................  Product Type.
Origination Date.............  Note Date.
Origination Loan Balance.....  Origination Loan Balance.

[[Page 19071]]

 
Origination Scheduled P&I....  Cutoff Scheduled P&I.
Origination Appraised Value..  Most Recent Appraised Value.
Loan-to-Value Ratio..........  Loan-To-Value Ratio.
Current Assets...............  Current Assets.
Current Liabilities..........  Current Liabilities.
Total Assets.................  Total Assets.
Total Liabilities............  Total Liabilities.
Gross Farm Revenue...........  Gross Farm Revenue.
Net Farm Income..............  Net Farm Income.
Depreciation.................  Depreciation.
Interest on Capital Debt.....  Interest On Capital Debt.
Capital Lease Payments.......  Capital Lease Payments.
Living Expenses..............  Living Expenses.
Income & FICA Taxes..........  Income & FICA Taxes.
Net Off-Farm Income..........  Net Off-Farm Income.
Total Debt Service...........  Total Debt Service.
Guarantee Fee................  Commitment Fee Rate.
Seasoned Loan................  Seasoned Loan.
------------------------------------------------------------------------

    (2) From the loan-level data, you must identify the geographic 
distribution by state of Farmer Mac's loan portfolio and enter the 
current loan balance for each state in the ``Data Inputs'' 
worksheet. The lifetime age-adjustment of origination year loss 
rates was discussed in section 2.0, ``Credit Risk.'' The lifetime 
age-adjusted loss rates, blended across standby and non-standby 
program assets are entered in the ``Risk Measures'' worksheet of the 
stress test. The stress test application of the loss rates is 
discussed in section 4.3, ``Risk Measures.''
    e. Other Data Requirements. Other data elements are taxes paid 
over the previous 2 years, the corporate tax schedule, selected line 
items from Schedule RS-C of the Call Report, and 10-year CMT 
information as discussed in section 3.1 entitled, ``Process for 
Calculating the Interest Rate Movement.'' The stress test uses the 
corporate tax schedule and previous taxes paid to determine the 
appropriate amount of taxes, including available loss carry-backs 
and loss carry-forwards. Three line items found in sections Part II 
2.a. and 2.b. of Call Report Schedule RS-C Capital Calculation must 
also be entered in the ``Data Inputs'' sheet. The two line items 
found in Part II 2.a. contain the dollar volume off-balance sheet 
assets relating to the Farmer Mac I and II programs. The off-balance 
sheet program asset dollar volumes are used to calculate the 
operating expense regression on a quarterly basis. The single-line 
item found in Part II 2.b. provides the amount of other off-balance 
sheet obligations and is presented in the balance sheet section of 
the stress test for purposes of completeness. The 10-year CMT 
quarterly average of the monthly series and the 12-month average of 
the monthly series must be entered in the ``Data Inputs'' sheet. 
These two data elements are used to determine the starting interest 
rate and the level of the interest rate shock applied in the stress 
test.

4.2  Assumptions and Relationships

    a. The stress test assumptions are summarized on the worksheet 
called ``Assumptions and Relationships.'' Some of the entries on 
this page are direct user entries. Other entries are relationships 
generated from data supplied by Farmer Mac or other sources as 
discussed in section 4.1, ``Data Inputs.'' After current financial 
data are entered, the user selects the date for running the stress 
test. This action causes the stress test to identify and select the 
appropriate data from the ``Data Inputs'' worksheet. The next 
section highlights the degree of disaggregation needed to maintain 
reasonably representative financial characterizations of Farmer Mac 
in the stress test. Several specific assumptions are established 
about the future relationships of account balances and how they 
evolve.
    b. From the data and assumptions, the stress test computes pro 
forma financial statements for 10 years. The stress test must be run 
as a ``steady state'' with regard to program balances, and where 
possible, will use information gleaned from recent financial 
statements and other data supplied by Farmer Mac to establish 
earnings and cost relationships on major program assets that are 
applied forward in time. As documented in the stress test, entries 
of ``1'' imply no growth and/or no change in account balances or 
proportions relative to initial conditions. The interest rate risk 
and credit loss components are applied to the stress test through 
time. The individual sections of that worksheet are:
    (1) Elements related to cashflows, earnings rates, and 
disposition of discontinued program assets.
    (A) The stress test accounts for earnings rates by asset class 
and cost rates on funding. The stress test aggregates investments 
into the categories of: Cash and money market securities; commercial 
paper; certificates of deposit; agency mortgage-backed securities 
and collateralized mortgage obligations; and other investments. With 
FCA's concurrence, Farmer Mac is permitted to further disaggregate 
these categories. Similarly, we may require new categories for 
future activities to be added to the stress test. Loan items 
requiring separate accounts include the following:
    (i) Farmer Mac I program assets post-1996 Act;
    (ii) Farmer Mac I program assets post-1996 Act Swap balances;
    (iii) Farmer Mac I program assets pre-1996 Act;
    (iv) Farmer Mac I AgVantage securities;
    (v) Loans held for securitization; and
    (vi) Farmer Mac II program assets.
    (B) The stress test also uses data elements related to 
amortization and prepayment experience to calculate and process the 
implied rates at which asset and liability balances terminate or 
``roll off'' through time. Further, for each category, the stress 
test has the capacity to track account balances that are expected to 
change through time for each of the categories in paragraph b. 
(1)(A) of this section. For purposes of the stress test, all assets 
are assumed to maintain a ``steady state'' with the implication that 
any principal balances retired or prepaid are replaced with new 
balances. The exceptions are that expiring pre-1996 Act program 
assets are replaced with post-1996 Act program assets.
    (2) Elements related to other balance sheet assumptions through 
time. As well as interest earning assets, the other categories of 
the balance sheet that are modeled through time include interest 
receivable, guarantee fees receivable, prepaid expenses, accrued 
interest payable, accounts payable, accrued expenses, reserves for 
losses (loans held and guaranteed securities), and other off-balance 
sheet obligations. The stress test is consistent with Farmer Mac's 
existing reporting categories and practices. If reporting practices 
change substantially, the list in this section will be adjusted 
accordingly. The stress test has the capacity to have the balances 
in each of these accounts determined based upon existing 
relationships to other earning accounts, to keep their balances 
either in constant proportions of loan or security accounts, or to 
evolve according to a user-selected rule. For purposes of the stress 
test, these accounts are to remain constant relative to the 
proportions of their associated balance sheet accounts that 
generated the accrued balances.
    (3) Elements related to income and expense assumptions. Several 
other parameters that are required to generate pro forma financial 
statements may not be easily captured from historic data or may have 
characteristics that suggest that they be individually supplied. 
These parameters are the gain on agricultural mortgage-backed 
securities (AMBS) sales, miscellaneous income, operating expenses, 
reserve

[[Page 19072]]

requirement, and guarantee fees. The stress test assumes a 75 basis 
points gain rate on sales of AMBS securities, recognizing that this 
parameter, while reasonably related to recent performance, may 
change with changes in market conditions. Miscellaneous income as a 
percentage of total assets contributes 2 basis points to income.
    (A) Fixed costs and variable costs are determined from 
historical financial data by running a regression (ordinary least 
squares) of operating expenses, excluding provision expense and 
taxes, to on-and off-balance sheet assets, including investments and 
Farmer Mac program assets. The regression equation can be expressed 
as:

    Y =  + 1 ln(X) + 
2D

    (B) Where Y is operating expenses excluding provision for loans 
and tax expenses; ln(X) is the natural log of investments and Farmer 
Mac program assets held on-and off-balance sheet, and D is a dummy 
variable (1 represents pre-1996 and 0 represents post-1996). The 
regression is estimated using ordinary least squares, where 
() is the intercept, (1) is the 
coefficient on the logarithm of on-balance sheet program assets and 
investments, and off-balance sheet program assets, and 
(2) is the coefficient on the dummy variable.
    (C) To run the stress test, the operating expense regression 
equation must be re-estimated using data from Farmer Mac's inception 
to the most recent quarterly financial information and the resulting 
coefficient entered into the ``Assumptions and Relationships'' 
worksheet. As additional data accumulate, the specification will be 
re-examined and modified if we deem changing the specification 
results in a more appropriate representation of operating expenses.
    (D) The reserve requirement as a fraction of loan assets can 
also be specified. However, the stress test is run with the reserve 
requirement set to zero. Setting the parameter to zero causes the 
stress test to calculate a risk-based capital level that is 
comparable to regulatory capital, which includes reserves. Thus, the 
risk-based capital requirement contains the regulatory capital 
required, including reserves. The amount of total capital that is 
allocated to the reserve account is determined by GAAP. The 
guarantee rates applied in the stress test are: post-1996 Farmer Mac 
I assets (50 basis points, current weighted average of 42 basis 
points); pre-1996 Farmer Mac I assets (25 basis points); and Farmer 
Mac II assets (25 basis points).
    (4) Elements related to earnings rates and funding costs.
    (A) The stress test can accommodate numerous specifications of 
earnings and funding costs. In general, both relationships are tied 
to the 10-year CMT interest rate. Specifically, each investment 
account, each loan item, and each liability account can be specified 
as fixed rate, or fixed spread to the 10-year CMT with initial rates 
determined by actual data. The stress test calculates specific 
spreads (weighted average yield less initial 10-year CMT) by 
category from the weighted average yield data supplied by Farmer Mac 
as described earlier. For example, the fixed spread for Farmer Mac I 
program post-1996 Act mortgages is calculated as follows:

Fixed Spread = Weighted Average Yield less 10-year CMT
0.014 = 0.0694-0.0554

    (B) The resulting fixed spread of 1.40 percent is then added to 
the 10-year CMT when it is shocked to determine the new yield. For 
instance, if the 10-year CMT is shocked upward by 300 basis points, 
the yield on Farmer Mac I program post-1996 Act loans would change 
as follows:

Yield = Fixed Spread + 10-year CMT
.0994 = .014 + .0854

    (C) The adjusted yield is then used for income calculations when 
generating pro forma financial statements. All fixed-spread asset 
and liability classes are computed in an identical manner using 
starting yields provided as data inputs from Farmer Mac. The fixed-
yield option holds the starting yield data constant for the entire 
10-year stress test period. You must run the stress test using the 
fixed-spread option for all accounts except for discontinued program 
activities, such as Farmer Mac I program loans made before the 1996 
Act. For discontinued loans, the fixed-rate specification must be 
used if the loans are primarily fixed-rate mortgages.
    (5) Elements related to interest rate shock test. As described 
earlier, the interest rate shock test is implemented as a single set 
of forward interest rates. The stress test applies the up-rate 
scenario and down-rate scenario separately. The stress test also 
uses the results of Farmer Mac's shock test, as described in 
paragraph c. of section 4.1, ``Data Inputs,'' to calculate the 
impact on equity from a stressful change in interest rates as 
discussed in section 3.0 titled, ``Interest Rate Risk.'' The stress 
test uses a schedule relating a change in interest rates to a change 
in the market value of equity. For instance, if interest rates are 
shocked upward so that the percentage change is 262 basis points, 
the linearly interpolated effective estimated duration of equity is 
-6.7405 years given Farmer Mac's interest rate measurement results 
at 250 and 300 basis points of -6.7316 and -6.7688 years, 
respectively found on the effective duration schedule. The stress 
test uses the linearly interpolated estimated effective duration for 
equity to calculate the market value change by multiplying duration 
by the base value of equity before any rate change from Farmer Mac's 
interest rate risk measurement results with the percentage change in 
interest rates.

4.3  Risk Measures

    a. This section describes the elements of the stress test in the 
worksheet named ``Risk Measures'' that reflect the interest rate 
shock and credit loss requirements of the stress test.
    b. As described in section 3.1, the stress test applies the 
statutory interest rate shock to the initial 10-year CMT rate. It 
then generates a series of fixed annual interest rates for the 10-
year stress period that serve as indices for earnings yields and 
cost of funds rates used in the stress test. (See the ``Risk 
Measures'' worksheet for the resulting interest rate series used in 
the stress test.)
    c. The blended loss rates by state, as described in section 2.5 
entitled, ``Calculation of Loss Rates for Use in the Stress Test,'' 
are entered into the ``Risk Measures'' worksheet and applied to the 
loan balances that exist in each state as reported in the initial 
loan portfolio of Farmer Mac. The initial distribution of loan 
balances by state is used to allocate new loans that replace loan 
products that roll off the balance sheet through time. The loss 
rates are applied both to the initial volume and to new loan volume 
that replaces expiring loans. The total life of loan losses that are 
expected at origination are then allocated through time based on a 
set of user entries describing the time-path of losses.
    d. The loss rates estimated in the credit risk component of the 
stress test are based on an origination year concept, adjusted for 
loan seasoning. All losses arising from loans originated in a 
particular year are expressed as lifetime age-adjusted losses 
irrespective of when the losses actually occur. The fraction of the 
origination year loss rates that must be used to allocate losses 
through time are 43 percent to year 1, 17 percent to year 2, 11.66 
percent to year 3, and 4.03 percent for the remaining years. The 
total allocated losses in any year are expressed as a percent of 
loan volume in that year to reflect the conversion to exposure year.

4.4  Loan and Cashflow Accounts

    The worksheet labeled ``Loan and Cashflow Data'' contains the 
categorized loan data and cashflow accounting relationships that are 
used in the stress test to generate projections of Farmer Mac's 
performance and condition. As can be seen in the worksheet, the 
steady-state formulation results in account balances that remain 
constant except for the effects of discontinued programs. For assets 
with maturities under 1 year, the results are reported for 
convenience as though they matured only one time per year with the 
additional convention that the earnings/cost rates are annualized. 
For the pre-1996 Act assets, maturing balances are added back to 
post-1996 Act account balances. The liability accounts are used to 
satisfy the accounting identity, which requires assets to equal 
liabilities plus owner equity. In addition to the replacement of 
maturities under a steady state, liabilities are increased to 
reflect net losses or decreased to reflect resulting net gains. 
Adjustments must be made to the long- and short-term debt accounts 
to maintain the same relative proportions as existed at the 
beginning period from which the stress test is run. The primary 
receivable and payable accounts are also maintained on this 
worksheet, as is a summary balance of the volume of loans subject to 
credit losses.

4.5  Income Statements

    a. Information related to income performance through time is 
contained on the worksheet named ``Income Statements.'' Information 
from the first period balance sheet is used in conjunction with the 
earnings and cost-spread relationships from Farmer Mac supplied data 
to generate the first period's income statement. The same set of 
accounts is maintained in this worksheet as ``Loan and Cashflow 
Accounts'' for consistency in reporting each annual period of the 
10-year stress period of the test. The income from each interest-
bearing account is

[[Page 19073]]

calculated, as are costs of interest-bearing liabilities. In each 
case, these entries are the associated interest rate for that period 
multiplied by the account balances.
    b. The credit losses described in section 2.0, ``Credit Risk,'' 
are transmitted through the provision account as is any change 
needed to re-establish the target reserve balance. For determining 
risk-based capital, the reserve target is set to zero as previously 
indicated in section 4.2. Under the income tax section, it must 
first be determined whether it is appropriate to carry forward tax 
losses or recapture tax credits. The tax section then establishes 
the appropriate income tax liability that permits the calculation of 
final net income (loss), which is credited (debited) to the retained 
earnings account.

4.6  Balance Sheets

    a. The worksheet named ``Balance Sheets'' is used to construct 
pro forma balance sheets from which the capital calculations can be 
performed. As can be seen in the Excel spreadsheet, the worksheet is 
organized to correspond to Farmer Mac's normal reporting practices. 
Asset accounts are built from the initial financial statement 
conditions, and loan and cashflow accounts. Liability accounts 
including the reserve account are likewise built from the previous 
period's results to balance the asset and equity positions. The 
equity section uses initial conditions and standard accounts to 
monitor equity through time. The equity section maintains separate 
categories for increments to paid-in-capital and retained earnings 
and for mark-to-market effects of changes in account values. The 
process described in the ``Capital'' worksheet uses the initial 
retained earnings and paid-in-capital account to test for the change 
in initial capital that permits conformance to the statutory 
requirements. Therefore, these accounts must be maintained 
separately for test solution purposes.
    b. The market valuation changes due to interest rate movements 
must be computed utilizing the linearly interpolated schedule of 
estimated equity effects due to changes in interest rates, contained 
in the ``Assumptions & Relationships'' worksheet. The stress test 
calculates the dollar change in the market value of equity by 
multiplying the base value of equity before any rate change from 
Farmer Mac's interest rate risk measurement results, the linearly 
interpolated estimated effective duration of equity, and the 
percentage change in interest rates. In addition, the earnings 
effect of the measured dollar change in the market value of equity 
is estimated by multiplying the dollar change by the blended cost of 
funds rate found on the ``Assumptions & Relationships'' worksheet. 
Next, divide by 2 the computed earnings effect to approximate the 
impact as a theoretical shock in the interest rates that occurs at 
the mid-point of the income cycle from period t0 to 
period t1. The measured dollar change in the market value 
of equity and related earnings effect are then adjusted to reflect 
any tax related benefits. Tax adjustments are determined by 
including the measured dollar change in the market value of equity 
and the earnings effect in the tax calculations found in the 
``Income Statements'' worksheet. This approach ensures that the 
value of equity reflects the economic loss or gain in value of 
Farmer Mac's capital position from a change in interest rates and 
reflects any immediate tax benefits that Farmer Mac could realize. 
Any tax benefits in the module are posted through the income 
statement by adjusting the net taxes due before calculating final 
net income. Final net income is posted to accumulated unretained 
earnings in the shareholders' equity portion of the balance sheet. 
The tax section is also described in section 4.5 entitled, ``Income 
Statements.''
    c. After one cycle of income has been calculated, the balance 
sheet as of the end of the income period is then generated. The 
``Balance Sheet'' worksheet shows the periodic pro forma balance 
sheets in a format convenient to track capital shifts through time.
    d. The stress test considers Farmer Mac's balance sheet as 
subject to interest rate risk and, therefore, the capital position 
reflects mark-to-market changes in the value of equity. This 
approach ensures that the stress test captures interest rate risk in 
a meaningful way by addressing explicitly the loss or gain in value 
resulting from the change in interest rates required by the statute.

4.7  Capital

    The ``Capital'' worksheet contains the results of the required 
capital calculations as described in section 5.0, and provides a 
method to calculate the level of initial capital that would permit 
Farmer Mac to maintain positive capital throughout the 10-year 
stress test period.

5.0  Capital Calculation

    a. The stress test computes regulatory capital as the sum of the 
following:
    (1) The par value of outstanding common stock;
    (2) The par value of outstanding preferred stock;
    (3) Paid-in capital;
    (4) Retained earnings; and
    (5) Reserve for loan and guarantee losses.
    b. Inclusion of the reserve account in regulatory capital is an 
important difference compared to minimum capital as defined by the 
statute. Therefore, the calculation of reserves in the stress test 
is also important because reserves are reduced by loan and guarantee 
losses. The reserve account is linked to the income statement 
through the provision for loan-loss expense (provision). Provision 
expense reflects the amount of current income necessary to rebuild 
the reserve account to acceptable levels after loan losses reduce 
the account or as a result of increases in the level of risky 
mortgage positions, both on-and off-balance sheet. Provision 
reversals represent reductions in the reserve levels due to reduced 
risk of loan losses or loan volume of risky mortgage positions. When 
calculating the stress test, the reserve is maintained at zero to 
result in a risk-based capital requirement that includes reserves, 
thereby making the requirement comparable to the statutory 
definition of regulatory capital. By setting the reserve requirement 
to zero, the capital position includes all financial resources 
Farmer Mac has at its disposal to withstand risk.

5.1  Method of Calculation

    a. Risk-based capital is calculated in the stress test as the 
minimum initial capital that would permit Farmer Mac to remain 
solvent for the ensuing 10 years. To this amount, an additional 30 
percent is added to account for managerial and operational risks not 
reflected in the specific components of the stress test.
    b. The relationship between the solvency constraint (i.e., 
future capital position not less than zero) and the risk-based 
capital requirement reflects the appropriate earnings and funding 
cost rates that may vary through time based on initial conditions. 
Therefore, the minimum capital at a future point in time cannot be 
directly used to determine the risk-based capital requirement. To 
calculate the risk-based capital requirement, the stress test 
includes a section to solve for the minimum initial capital value 
that results in a minimum capital level over the 10 years of zero at 
the point in time that it would actually occur. In solving for 
initial capital, it is assumed that reductions or additions to the 
initial capital accounts are made in the retained earnings accounts, 
and balanced in the debt accounts at terms proportionate to initial 
balances (same relative proportion of long- and short-term debt at 
existing initial rates). Because the initial capital position 
affects the earnings, and hence capital positions and appropriate 
discount rates through time, the initial and future capital are 
simultaneously determined and must be solved iteratively. The 
resulting minimum initial capital from the stress test is then 
reported on the ``Capital'' worksheet of the stress test. The 
``Capital'' worksheet includes an element that uses Excel's 
``solver'' or ``goal seek'' capability to calculate the minimum 
initial capital that, when added (subtracted) from initial capital 
and replaced with debt, results in a minimum capital balance over 
the following 10 years of zero.

    Dated: April 5, 2001.
Kelly Mikel Williams,
Secretary, Farm Credit Administration Board.
[FR Doc. 01-8923 Filed 4-11-01; 8:45 am]
BILLING CODE 6705-01-P