[Federal Register Volume 66, Number 178 (Thursday, September 13, 2001)]
[Rules and Regulations]
[Pages 47730-47875]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-18459]
[[Page 47729]]
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Part II
Department of Housing and Urban Development
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Office of Federal Housing Enterprise Oversight
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12 CFR Part 1750
Risk-Based Capital; Final Rule
Federal Register / Vol. 66, No. 178 / Thursday, September 13, 2001 /
Rules and Regulations
[[Page 47730]]
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DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT
Office of Federal Housing Enterprise Oversight
12 CFR Part 1750
RIN 2550-AA02
Risk-Based Capital
AGENCY: Office of Federal Housing Enterprise Oversight, HUD.
ACTION: Final rule.
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SUMMARY: The Office of Federal Housing Enterprise Oversight (OFHEO) is
directed by the Federal Housing Enterprises Financial Safety and
Soundness Act of 1992 to issue a risk-based capital regulation for the
Federal Home Loan Mortgage Corporation and the Federal National
Mortgage Association (collectively, the Enterprises). The regulation
specifies the risk-based capital stress test that will be used to
determine each Enterprise's risk-based capital requirement and, along
with the minimum capital requirement, to determine each Enterprise's
capital classification for purposes of possible supervisory action.
EFFECTIVE DATE: September 13, 2001.
FOR FURTHER INFORMATION CONTACT: Edward J. Szymanoski, Acting Associate
Director, Office of Risk Analysis and Model Development; Dorothy J.
Acosta, Deputy General Counsel; or David A. Felt, Associate General
Counsel, Office of Federal Housing Enterprise Oversight, 1700 G Street,
NW., Fourth Floor, Washington, DC 20552, telephone (202) 414-3800 (not
a toll-free number). The telephone number for the telecommunications
device for the deaf is (800) 877-8339.
SUPPLEMENTARY INFORMATION:
I. Introduction
A. Background
The Office of Federal Housing Enterprise Oversight (OFHEO) was
established by title XIII of the Housing and Community Development Act
of 1992, Pub. L. No. 102-550, known as the Federal Housing Enterprises
Financial Safety and Soundness Act of 1992 (1992 Act). OFHEO is an
independent office within the U.S. Department of Housing and Urban
Development (HUD) with responsibility for examining and regulating the
Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal
National Mortgage Association (Fannie Mae) (collectively, the
Enterprises) and ensuring that they are adequately capitalized. The
1992 Act expressly directs OFHEO's Director (the Director) to issue a
regulation establishing the risk-based capital standard.\1\
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\1\ 12 U.S.C. 4513(b)(1).
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Fannie Mae and Freddie Mac are government-sponsored Enterprises
that engage in two principal businesses: investing in residential
mortgages and guaranteeing securities backed by residential mortgages.
The securities the Enterprises guarantee and the debt instruments they
issue are not backed by the full faith and credit of the United States
and nothing in this document should be construed otherwise.\2\
Nevertheless, financial markets treat Enterprise securities more
favorably than securities issued by comparable firms. The market prices
for Enterprise debt and mortgage-backed securities (MBS) and the fact
that the market does not require that those securities be rated by a
nationally recognized rating statistical organization suggest that
investors perceive that the government implicitly guarantees those
securities. Factors contributing to this perception include the
Enterprises' public purposes, their Congressional charters, their
potential direct access to U.S. Department of Treasury (Treasury)
funds, and the statutory exemptions of their debt and MBS from
otherwise mandatory investor protection provisions.\3\
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\2\ See Federal Home Loan Mortgage Corporation Act, section
306(h)(2) (12 U.S.C. 1455(h)(2)); Federal National Mortgage
Association Charter Act, section 304(b) (12 U.S.C. 1719(b)); and
1992 Act, section 1302(4) (12 U.S.C. 4501(4)).
\3\ See, e.g., 12 U.S.C. 24 (authorizing unlimited investment by
national banks in obligations of or issued by the Enterprises); 12
U.S.C. 1455(g), 1719(d), 1723(c) (exempting securities from
oversight from Federal regulators); 15 U.S.C. 77r-1(a) (preempting
State law that would treat Enterprise securities differently from
obligations of the United States for investment purposes); 15 U.S.C.
77r-1(c) (exempting Enterprise securities from State blue sky laws).
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B. Statutory Requirements for Risk-Based Capital
The final rule implements the 1992 Act's requirement to establish,
by regulation, a risk-based capital ``stress test'' to determine the
amount of capital each Enterprise needs to survive a ten-year period
characterized by large credit losses and large movements in interest
rates (stress period).\4\ The 1992 Act also provides that, in order to
meet its risk-based capital standard, each Enterprise is required to
maintain an additional 30 percent of this amount to protect against
management and operations risk.\5\ The level of capital \6\ required
under this standard for an Enterprise will reflect that Enterprise's
specific risk profile at the time the stress test is run.
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\4\ 12 U.S.C. 4611.
\5\ 12 U.S.C. 4611(c)(2).
\6\ For purposes of the risk-based capital standard, the term
``capital'' means ``total capital'' as defined under section
1303(18) of the 1992 Act (12 U.S.C. 4502(18)).
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The 1992 Act requires that the stress test subject each Enterprise
to large credit losses on the mortgages it owns or guarantees. The
rates of default and severity that yield these losses must be
reasonably related to the highest rates of default and severity of
mortgage losses experienced during a period of at least two consecutive
years in contiguous areas of the United States that together contain at
least five percent of the total U.S. population (benchmark loss
experience).\7\ The 1992 Act also prescribes two interest rate
scenarios, one with rates falling and the other with rates rising.\8\
The risk-based capital amount is based on whichever scenario requires
more capital for the Enterprise. In prescribing the two scenarios, the
1992 Act describes the path of the ten-year constant maturity yield
(CMT) for each scenario and directs OFHEO to establish the yields on
Treasury instruments of other maturities in a manner reasonably related
to historical experience and judged reasonable by the Director.
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\7\ 12 U.S.C. 4611(a)(1).
\8\ 12 U.S.C. 4611(a)(2).
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Congress provided OFHEO significant discretion to determine many
aspects of the risk-based capital test. This flexibility is evidenced
by section 1361(b), which states that ``[i]n establishing the risk-
based capital test under subsection (a), the Director shall take into
account appropriate distinctions among types of mortgage products,
differences in seasoning of mortgages, and any other factors the
Director considers appropriate.'' \9\ The subsection further states
that other non-specified characteristics of the stress period, ``such
as prepayment experience and dividend policies, will be those
determined by the Director, on the basis of available information, to
be most consistent with the stress period.'' \10\ The statute also
provides OFHEO flexibility in establishing other aspects of the stress
test, including ``the rate of default and severity,'' \11\ the yields
on Treasury securities relative to the ten-year CMT yield,\12\ and the
definition of ``type of mortgage product.'' \13\
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\9\ 12 U.S.C. 4611(b)(1).
\10\ 12 U.S.C. 4611(b)(2).
\11\ 12 U.S.C. 4611(a)(1).
\12\ 12 U.S.C. 4611(a)(2).
\13\ 12 U.S.C. 4611(d)(2).
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[[Page 47731]]
The 1992 Act requires that, initially, the stress test not provide
for the conduct of new business by the Enterprises during the stress
period, except to fulfill contractual commitments to purchase mortgages
or issue securities. Four years after the final risk-based capital
regulation is issued, OFHEO may modify the stress test to incorporate
assumptions about additional new business conducted during the stress
period.\14\ In doing so, OFHEO is required to take into consideration
the results of studies conducted by the Congressional Budget Office and
the Comptroller General of the United States on the advisability and
appropriate form of new business assumptions. The 1992 Act requires
that the studies be completed within the first year after issuance of
the final regulation.\15\
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\14\ 12 U.S.C. 4611(a)(3)(B) and (D).
\15\ 12 U.S.C. 4611(a)(3)(C).
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C. Rulemaking Chronology
OFHEO has issued a series of Federal Register notices soliciting
comment on the development of the risk-based capital regulation. The
first notice, an Advance Notice of Proposed Rulemaking (ANPR),\16\
sought public comment on a number of issues relating to the development
of the regulation.\17\ OFHEO received 17 comments on the ANPR from a
variety of interested parties, including other Federal agencies, Fannie
Mae, Freddie Mac, trade associations, and financial organizations.
OFHEO considered these comments in the development of two subsequent
Notices of Proposed Rulemaking (NPRs), each addressing different
components of the risk-based capital regulation. The first Notice of
Proposed Rulemaking (NPR1) \18\ addressed two issues: (1) The
methodology for identifying the benchmark loss experience, and (2) the
use of OFHEO's House Price Index (HPI) to update original loan-to-value
ratios (LTVs) and to determine house price appreciation paths during
the stress period.\19\ NPR1 included OFHEO's responses to all of the
ANPR comments that related to those two areas.\20\ The second Notice of
Proposed Rulemaking (NPR2) proposed the remaining specifications of the
stress test, including how the HPI would be used and how losses
predicted by the stress test would be calibrated to the benchmark loss
experience.\21\ In addition, OFHEO issued a notice soliciting reply
comments to provide interested parties an opportunity to respond to
other commenters that addressed NPR2.\22\
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\16\ Risk-Based Capital, ANPR, 60 FR 7468, February 8, 1995.
\17\ The comment period for the ANPR ended on May 9, 1995, and
was extended through June 8, 1995. Risk-Based Capital, Extension of
Public Comment Period for ANPR, 60 FR 25174, May 11, 1995.
\18\ Risk-Based Capital, NPR1, 61 FR 29592, June 11, 1996.
\19\ 61 FR 29616, June 11, 1996.
\20\ The comment period for NPR1 ended on September 9, 1996, and
was extended through October 24, 1996. Risk-Based Capital, Extension
of Public Comment Period for NPR1, 61 FR 42824, August 19, 1996.
\21\ Risk-Based Capital, Second Notice of Proposed Rulemaking
(NPR2), 64 FR 18084, April 13, 1999. The agency extended the comment
period twice. The first extension was until November 10, 1999 (64 FR
31756, June 14, 1999), and the second extension was until March 10,
2000 (64 FR 56274, October 19, 1999).
\22\ Risk-Based Capital, Solicitation of Reply Comments, 65 FR
13251, March 13, 2000.
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OFHEO received comments from 11 commenters on NPR1 and 48
commenters on NPR2. These commenters included Fannie Mae, Freddie Mac,
housing and financial trade associations, financial services companies,
housing advocacy groups, and other interested parties. Approximately 12
commenters, including the Enterprises, GE Capital Mortgage Corporation,
Mortgage Insurance Companies of America, The Consumer Mortgage
Coalition, and the Mortgage Bankers Association of America submitted
reply comments to NPR2.
The final rule reflects OFHEO's consideration of all of the
comments on NPR1 and NPR2, including the reply comments. A summary of
the comments by topic and OFHEO's response is set forth below in III.,
Comments and Responses.
II. Summary of the Stress Test
A. Overview
OFHEO's risk-based capital regulation is part of a larger
regulatory framework for the Enterprises that includes a minimum
capital requirement and a comprehensive examination program. The
purpose of this regulatory framework is to reduce the risk that an
Enterprise will fail by ensuring that the Enterprises are capitalized
adequately and operating safely, in accordance with the 1992 Act. The
1992 Act requires OFHEO to develop a stress test that simulates the
effects of ten years of adverse economic conditions on the existing
assets, liabilities, and off-balance-sheet obligations of the
Enterprises. OFHEO issued for comment two proposals that implement this
requirement.
This summary describes the stress test adopted in the final rule
after considering extensive comments from interested parties on the
risk-based capital proposals. It includes changes made to the stress
test to address the concerns of the commenters where possible and
appropriate. These changes are consistent with applicable statutory
requirements and with OFHEO's obligation to promote safety and
soundness of the housing finance system and to ensure the Enterprises'
ability to fulfill their important public missions. These changes are
discussed in section III., Comments and Responses. In addition, the
final rule includes technical and clarifying changes to the risk-based
capital proposals.
The final rule describes a stress test that meets the statutory
requirements of the 1992 Act and captures accurately and appropriately
the risks of the Enterprises' businesses. The stress test determines,
as of a point in time, how much capital each Enterprise would require
to survive the economically stressful conditions outlined by the 1992
Act. At a minimum, the stress test will be run quarterly using data on
interest rates, housing markets, and an Enterprise's assets,
liabilities, off-balance-sheet items, and operations. The stress test
is comprised of econometric, financial, and accounting models used to
simulate Enterprise financial performance over a ten-year period called
the ``stress period.'' The final regulation determines the risk-based
capital requirement by computing the amount of starting capital that
would permit an Enterprise to maintain a positive capital position
throughout the stress period (stress test capital) and adding 30
percent of that amount to cover management and operations risk.
B. Data
OFHEO uses data from the Enterprises and public sources to run the
stress test. The stress test utilizes data that characterize, at a
point in time, an Enterprise's assets, liabilities, and off-balance
sheet obligations, as well as data on economic conditions, such as
interest rates and house prices. OFHEO obtains data on economic
conditions from public sources. The Enterprises are required to submit
data to OFHEO at least quarterly for all on- and off-balance-sheet
instruments in a specified format, which is input directly into the
computer model. This data submission is called the Risk-Based Capital
Report (RBC Report) and serves as the financial ``starting position''
of an Enterprise for the date for which the stress test is run.
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As a part of the RBC Report, the Enterprises report aggregated data
from groups of loans having similar risk characteristics. The loans
within these groups share common values for a set of classification
variables. For single family loans, classification variables are
original interest rate, current interest rate, original loan-to-value
ratio (LTV), mortgage age, Census Division, loan size, status as
securitized or unsecuritized, status as government or conventional
loan, and product type (e.g. fixed rate, adjustable rate, balloons).
Classification variables for multifamily loans are product type,
original interest rate, current interest rate, original LTV, debt
coverage ratio (DCR); \23\ book of business designation,\24\ status as
securitized or unsecuritized, status as Government or conventional
loan, status as interest only or amortizing, and a ratio update flag,
which indicates whether LTV and DCR were updated at acquisition. Both
single family and multifamily ARM loans are also classified by index,
rate reset period, payment reset period, and cap type. These
distinctions are associated with different risk characteristics. In
this way, over 24 million loans can be aggregated into the minimum
number of loan groups that captures important risk characteristics.
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\23\ DCR is the ratio of net operating income to mortgage
payment for a specific property.
\24\ ``Old book'' loans are those originated before 1988 for
Fannie Mae and before 1993 for Freddie Mac. All other multifamily
loans are considered ``new book'' loans.
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Loan groups of new mortgages are also created to simulate the
fulfillment of commitments to purchase and/or securitize mortgages that
are outstanding at the start of the stress test. The stress test adds
new single family mortgages in one of four product types: 30-year
fixed-rate, 15-year fixed-rate, one-year CMT adjustable-rate, and 7-
year balloon. The percentage of each type added is based on the
relative proportions of those types of loans securitized by an
Enterprise that were originated during the six months preceding the
start of the stress period. The mix of characteristics of these new
loans also reflects the characteristics of the loans originated during
the preceding six months. All new mortgages are considered to be
securitized.
In the down-rate scenario, described below, the stress test
specifies delivery of 100 percent of the loans that the Enterprise is
obligated to accept under outstanding commitment agreements. These
loans are added during the first three months of the stress period. In
the up-rate scenario, described below, only 75 percent of these loans
are added and deliveries are phased in during the first six months of
the stress period. The new loan groups are then treated like the loan
groups reported by the Enterprise in the RBC Report.
Because of the smaller number and greater diversity of the
Enterprises' nonmortgage financial instruments, the stress test
projects these cash flows at the individual instrument level, rather
than at a group level. The RBC Report includes the instrument
characteristics necessary to model the terms of the instruments, which
include both investment and debt securities and derivative contracts.
C. Stress Test Conditions
1. Benchmark Loss Experience
To identify the stressful credit conditions that are the basis for
credit losses in the stress test, (benchmark loss experience), OFHEO
uses a methodology based on historical analysis of newly originated,
30-year, fixed-rate, first-lien mortgages on owner-occupied, single
family properties. Using this methodology, OFHEO identifies the worst
cumulative credit losses experienced by loans originated during a
period of at least two consecutive years in contiguous states
comprising at least five percent of the U.S. population, as required by
the 1992 Act. Loans originated in Arkansas, Louisiana, Mississippi and
Oklahoma in 1983 and 1984 currently serve as the benchmark loss
experience. These loans (benchmark loans) had an average ten-year
cumulative default rate of 14.9 percent and an average ten-year loss
severity of 63.3 percent. The loss rate (default incidence times loss
severity in the event of default, without considering the effect of
credit enhancements) for this region and time period was 9.4 percent.
OFHEO will continue to monitor loss data and may choose to establish a
new benchmark loss experience if a higher loss rate for a different
region and time period is determined using this methodology.
When the single family models of default and prepayment are applied
to the benchmark loans, using the pattern of interest rates from the
benchmark time and place, losses are close to those of benchmark loans.
The difference results from the fact that OFHEO based its single family
default and prepayment models on all Enterprise historical loan data,
not just the limited data for benchmark loans for which the losses were
particularly severe. This difference provides the basis for calibration
factors for each LTV category, which the stress test applies to adjust
the single family default rates upward or downward, making them more
consistent with the benchmark loss experience. However, because the
stress test simulates the performance of an Enterprise's entire
mortgage portfolio at a point in time and includes loans of all types,
ages, and characteristics, overall Enterprise mortgage loss rates in
the stress test can be lower or higher than the loss rates for
benchmark loans, even with the calibration adjustment.
Because there were very few Enterprise multifamily loans in the
benchmark region and time period, the stress test uses patterns of
vacancy rates and rent growth rates that are consistent with the
benchmark time and place to determine property income, a key factor in
determining defaults for multifamily loans. In this way, the stress
test relates the performance of multifamily loans to the benchmark loss
experience.
2. Interest Rates
Interest rates are a key component of the adverse economic
conditions of the stress test. The 1992 Act specifies two paths for the
ten-year Constant Maturity Treasury yield (CMT) during the stress
period. During the first year of the stress period, the ten-year CMT:
Falls by the lesser of 600 basis points below the average
yield during the nine months preceding the stress period, or 60 percent
of the average yield during the three years preceding the stress
period, but in no case to a yield less than 50 percent of the average
yield during the preceding nine months (down-rate scenario); or
Rises by the greater of 600 basis points above the average
yield during the nine months preceding the stress period, or 160
percent of the average yield during the three years preceding the
stress period, but in no case to a yield greater than 175 percent of
the average yield during the preceding nine months (up-rate scenario).
The ten-year CMT changes in twelve equal monthly increments from
the starting point, which is the average of the daily ten-year CMT
yields for the month preceding the stress period. The ten-year CMT
stays at the new level for the remainder of the stress period.
The stress test establishes the Treasury yield curve for the stress
period in relation to the prescribed movements in the ten-year CMT. In
the down-rate scenario, the yield curve is upward sloping during the
last nine years of the stress period; that is, short term rates are
lower than long term rates. In the up-rate scenario, the Treasury yield
curve is flat for the last nine years of the stress period; that is,
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yields of other maturities are equal to that of the ten-year CMT.
Because many different interest rates affect the Enterprises'
business performance, the ten-year CMT and the Treasury yield curve are
not the only interest rates that must be determined. For example,
current mortgage rates impact prepayment rates; adjustable-rate
mortgages periodically adjust according to various indexes; floating
rate securities (assets and liabilities) and many rates associated with
derivative contracts also adjust; and appropriate yields must be
established for new debt and investments issued during the stress test.
Thus, the stress test requires rates and indexes other than Treasury
yields for the entire stress period. Some of the key rates that are
used in the stress test are the Federal Funds Rate, London Inter-Bank
Offered Rate (LIBOR), Federal Home Loan Bank 11th District Cost of
Funds Index (COFI), and the Enterprise Cost of Funds. The stress test
establishes these rates and indexes using an average of the ratio of
each non-Treasury spread to its comparable CMT (the proportional
spread) for the two-year period prior to the start of the stress test.
Indexes of mortgage interest rates are calculated using the average
absolute basis-point spread for the same two-year period.
3. Property Values
The 1992 Act requires OFHEO to consider the effect of loan
``seasoning,'' which is defined as the change in LTVs over time.\25\
The analogous multifamily measure is current debt-service-coverage
ratio (DCR).
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\25\ 12 U.S.C. 4611(d)(1).
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For single family loans, the stress test updates the original LTV
to the start of the stress period, using the amortized loan balance and
a house price growth factor for the period between origination and the
start of the stress period. The house price growth factor is derived
from OFHEO's House Price Index (HPI) for the Census Division in which
the property is located. The stress test then applies the pattern of
house price changes from the benchmark time and place to compute
changes in property values during the stress period. The HPI values
represent average property value appreciation. In simulating mortgage
performance, the stress test also captures variations from average
house price movements, called dispersion. For this purpose, the stress
test uses dispersion parameters for the Census Division containing most
benchmark states, which OFHEO published along with the HPI for the
third quarter, 1996.
Multifamily property values are not updated in the stress test. LTV
at loan origination is the only variable that measures property values
directly in the multifamily model. If the original LTV is unknown, LTV
at loan acquisition is substituted. The effect of seasoning on
multifamily loans is captured by projecting changes in property income
during the stress period, based upon rent and vacancy indexes
consistent with the benchmark time and place.
When the ten-year CMT increases by more than 50 percent over the
average yield during the nine months preceding the stress period, the
stress test takes general price inflation into consideration. In such a
circumstance, adjustments are made to the house price and rent growth
paths during the stress period that correspond to the difference
between the ten-year CMT and the level reflecting a 50 percent increase
in the ten-year CMT. The stress test phases in this increase in equal
monthly increments during the last five years of the stress period.
D. Mortgage Performance
To simulate mortgage performance during the adverse conditions of
the stress period, the stress test uses statistical models that project
default, prepayment and loss severity rates during the stress period.
These models simulate the interaction of the patterns of house prices,
residential rents, and vacancy rates from the benchmark time and place
with stress test interest rates and mortgage risk characteristics, to
predict the performance of Enterprise loans throughout the stress test.
The default and prepayment models calculate the proportion of the
outstanding principal balance for each loan group that defaults or
prepays in each of the 120 months of the stress period. As described
below in further detail, the models are based on the historical
relationship of economic conditions, mortgage risk factors, and
mortgage performance, as reflected in the historical experience of the
Enterprises.
1. Single Family Default and Prepayment
The single family mortgage performance models were estimated using
available historical data for the performance of Enterprise loans in
the years 1979-1999. To simulate defaults and prepayments, the stress
test uses a 30-year fixed-rate loan model, an adjustable-rate loan
(ARM) model, and a third model for other products, such as 15-year
loans and balloon loans. Each of the three single family models was
separately estimated based on data for the relevant product types \26\
and includes a calibration adjustment by LTV category, so that the
results properly reflect a reasonable relationship to the benchmark
loss experience, as described earlier.
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\26\ Historical data sets for the ARM and other single family
product models were pooled with data for 30-year fixed-rate loans to
capture performance differences specific to product types relative
to 30-year fixed-rate loans.
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All three single family models simulate defaults and prepayments
based on the projected interest rates and property values, as described
above, and variables capturing the mortgage risk characteristics
described below. Certain variables are used only in prepayment
equations. The single family default and prepayment variables are
listed in Table 1.
Table 1.--Single Family Default & Prepayment Variables
------------------------------------------------------------------------
Single Single
Family Family
Variables for All Single Family Models Default Prepayment
Variables Variables
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Mortgage Age X X
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Original LTV X X
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Probability of Negative Equity X X
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Burnout X X
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Occupancy Status X X
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Relative Spread ............ X
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Yield Curve Slope ............ X
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Relative Loan Size ............ X
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Product Type (ARMs, Other Products only) X X
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Payment Shock (ARMs only) X X
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Initial Rate Effect (ARMs only) X X
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Mortgage Age--Patterns of mortgage default and prepayment
have characteristic age profiles; defaults and prepayments increase
during the first years following loan origination, with a peak between
the fourth and seventh years.
Original LTV--The LTV at the time of mortgage origination
serves as a proxy for factors relating to the financial status of a
borrower, which reflects the
[[Page 47734]]
borrower's future ability to make loan payments. Higher original LTVs,
which generally reflect fewer economic resources and greater financial
risk, increase the probability of default and lower the probability of
prepayment. The reverse is true for lower original LTVs.
Probability of Negative Equity--Borrowers whose current
loan balance is higher than the current value of their mortgaged
property (reflecting negative borrower equity) are more likely to
default than those with positive equity in their properties. The
probability of negative borrower equity within a loan group is a
function of (1) house price changes (based on the HPI), and
amortization of loan principal, which together establish the average
current LTV, and (2) the dispersion of actual house prices around the
HPI value. Thus, even when the average current LTV for a loan group is
less than one (positive equity), some percentage of the loans will have
LTVs greater than one (negative equity).
Burnout--This variable reflects whether a borrower has
passed up earlier opportunities to refinance at favorable interest
rates during the previous eight quarters. Such a borrower is less
likely to prepay the current loan and refinance, and more likely to
default in the future.
Occupancy Status--This variable reflects the higher
probability of default by investor-owners compared with that of owner-
occupants. The RBC Report specifies the proportion of investor loans
for each loan group.
Relative Spread--The stress test uses the relative spread
between the interest rate on a loan and the current market rate on
loans as a proxy for the mortgage premium value, which reflects the
value to a borrower of the option to prepay and refinance.
Yield Curve Slope--This variable measures the relationship
between short and long term interest rates. The shape of the yield
curve, which reflects expectations for the future levels of interest
rates, influences a borrower's decision to prepay a mortgage.
Relative Loan Size--This variable reflects whether a loan
is significantly larger or smaller than the State average. Generally,
lower balance loans are less likely to refinance (and therefore prepay)
because refinancing costs are proportionately larger, and the interest
savings are proportionately smaller, than a larger balance loan.
Product Type--The differences in performance between 30-
year fixed-rate loans and other products, such as ARM and balloon
loans, are captured by this variable.
Payment Shock--This variable captures the effect of
increasing or decreasing interest rates on the payments for ARMs.
Although a borrower with an ARM loan may still have positive equity in
the mortgaged property, the borrower may be unable to make a larger
monthly payment when interest rates increase, resulting in increases to
ARM default and prepayment rates. Conversely, decreasing interest rates
make it easier for borrowers to make monthly payments, resulting in
lower ARM default and prepayment rates.
Initial Rate Effect--Borrowers with ARM loans with a
``teaser rate'' (an initial interest rate lower than the market rate)
may experience payment shock even if market rates do not rise, as the
low teaser rate adjusts to the market rate over the first few years of
the loan. The stress test includes a variable which captures this
effect in the first three years of the life of the loan.
2. Multifamily Default and Prepayment
The stress test uses a statistical model for multifamily default
and a set of simple rules for multifamily prepayment. The default model
was estimated using historical data through 1999 on the performance of
Enterprise multifamily loans. As with the models of single family
mortgage performance, the multifamily default model simulates the
probability of default based on stress test conditions and loan group
risk characteristics. To account for specific risks associated with
multifamily loans, these loans are grouped somewhat differently than
are single family loans and have somewhat different explanatory
variables, to characterize stress test conditions. To characterize
stress test conditions, the multifamily model specifies interest rates,
rent growth rates, and vacancy rates.
The following variables are factors in determining the probability
of default for multifamily loan groups:
Mortgage Age--As with single family loans, the risk of
default on multifamily loans varies over their lives.
New Book Flags--These variables capture the performance
differences between the Enterprises' original multifamily programs and
their current, restructured programs. The reduced default risk under
the ``new book of business'' is more pronounced for fixed rate loans
than for balloon loans and ARMs, which are flagged separately.
Current DCR and Underwater DCR Flag--Rental property
owners tend not to default unless a property's debt coverage ratio
(DCR) is less than one, indicating insufficient net cash flow to
service the mortgage debt. The stress test updates the DCR of
multifamily loans during the stress period using rent and vacancy
indexes consistent with the benchmark loss experience. The higher the
DCR, the less likely that the borrower will default. Conversely, a DCR
below one indicates that the borrower cannot cover the mortgage
payment, significantly increasing the risk of default.
Original LTV--As with single family loans, the risk of
default for multifamily loan borrowers is greater for higher original
LTV loans than for lower original LTV loans.
Balloon Maturity Risk--When a balloon mortgage matures,
the borrower is required to pay off the outstanding balance in a lump
sum. This variable captures the greater risk of default in the year
before a balloon mortgage matures.
Ratio Update Flag--This variable captures the decreased
probability of default if the DCR and LTV were either calculated at
loan origination, or recalculated at Enterprise acquisition, in
accordance with current Enterprise standards.
To project prepayment rates for multifamily loans, the stress test
implements a simple set of prepayment rules. In the up-rate scenario,
multifamily loans do not prepay. In the down-rate scenario, two percent
of multifamily loan balances prepay each year if they are inside the
prepayment penalty time period. Outside the prepayment penalty period,
multifamily loans prepay at an annual rate of 25 percent.
3. Loss Severity
Loss severity is the net cost to an Enterprise of a loan default.
The stress test uses the costs associated with different events
following the default of a mortgage to determine the total loss or cost
to an Enterprise. Loss severity rates are computed as of the date of
default, and are expressed as a percentage of the unpaid principal
balance (UPB) of a defaulting loan.
In general, losses are composed of three elements associated with
loan foreclosure and disposition (sale) of the property: loss of
principal, transactions costs, and funding costs. Transaction costs
include expenses related to foreclosure, property holding costs (real
estate owned or REO costs) and disposition costs. For single family
loans, transactions costs are fixed percentages based on historical
averages computed from Enterprise data. For multifamily loans,
transactions costs are based on the average costs through 1995 from
Freddie Mac old book loans (See Footnote 24).
[[Page 47735]]
Loss of principal is the amount of defaulting loan UPB, offset by
the net proceeds of the sale (disposition) of the foreclosed property.
For single family loans, sale proceeds of foreclosed properties are a
fixed percentage of defaulting UPB, based on benchmark recovery rates
for real estate owned as a result of loan defaults (REO).\27\ For
multifamily loans, sale proceeds are a fixed percentage of the
defaulting UPB, based on REO recovery rates from Freddie Mac old book
loans through 1995.
---------------------------------------------------------------------------
\27\ Recovery rate is the proportion of defaulted UPB that is
recovered through the sale of the property.
---------------------------------------------------------------------------
Since foreclosure, property holding, disposition and associated
costs occur over time, the stress test calculates loss severity rates
by discounting the different elements of loss back to the time of
default, based on stress period interest rates. This discounting also
captures losses associated with funding costs, including passthrough
interest on sold loans, at appropriate interest rates. For single
family loans, the timing of each element is based on averages for the
benchmark loans; for multifamily loans it is based on the average for
Freddie Mac Old Book loans, using REO data through 1995. The loss
severity rates are used in the cash flow components of the stress test
to calculate credit losses for the Enterprises.
E. Other Credit Factors
1. Mortgage Credit Enhancements
A portion of Enterprise mortgage losses are offset by some form of
credit enhancement. Credit enhancements are contractual arrangements
with third parties that reduce Enterprise losses on defaulted loans. By
including the effect of mortgage credit enhancements, the stress test
more realistically reflects Enterprise risks related to mortgage
defaults and credit losses during the stress period.
The stress test captures many types of credit enhancements, with
differing depths and methods of coverage, for both single family and
multifamily loans. The stress test divides mortgage credit enhancements
into two categories--loan limit and aggregate limit. Loan limit credit
enhancements cover a specified percentage of losses on individual loans
with no limit on the aggregate amount paid under the contract. This
category includes mortgage insurance for single family loans and loss-
sharing agreements for multifamily loans. Aggregate limit credit
enhancements cover losses on a specified set of loans, up to a
specified aggregate amount. This category includes limited and
unlimited recourse to seller/servicers, indemnification, pool insurance
and modified pool insurance, cash or collateral accounts, third-party
letters of credit, spread accounts, subordination agreements, and FHA
risk-sharing.
The amount by which credit enhancements reduce monthly loss
severity rates is based on information reported by the Enterprises in
the RBC Report for the level of coverage for both loan limit and
aggregate limit credit enhancements for each loan group. The stress
test applies loan limit credit enhancements first. Then aggregate limit
credit enhancements are applied to the remainder of the loss balance,
up to the contractual limit. The stress test reduces the loss severity
rate for a specific loan group based on the combined loan limit and
aggregate limit credit enhancements associated with loans in that
group.
2. Counterparty Default
In addition to mortgage credit quality, the stress test considers
the creditworthiness of companies and financial instruments to which
the Enterprises have credit exposure. These include most mortgage
credit enhancement counterparties, securities held as assets, and
derivative contract counterparties.
For these contract or instrument counterparties, the stress test
reduces--or applies ``haircuts'' to--the amounts due from these
instruments or counterparties according to their level of risk. The
level of risk is determined by public credit ratings at the start of
the stress test, classified into five categories: AAA, AA, A, BBB and
unrated/below BBB. When no rating is available or the instrument or
counterparty has a rating below BBB (below investment grade), the
stress test applies a 100 percent haircut in the first month of the
stress test, with the exception of unrated seller/servicers, which are
treated as BBB, and unrated, unsubordinated obligations of government
sponsored enterprises, which are treated as AAA. For other categories,
the stress test phases in the haircuts monthly in equal increments
until the total reduction listed in Table 2 is reached five years into
the stress period. For the remainder of the stress period the haircut
applies.
Table 2.--Stress Test Final Haircuts by Credit Rating Category
------------------------------------------------------------------------
Non-
Ratings Classification Derivative derivative
------------------------------------------------------------------------
AAA 2% 5%
------------------------------------------------------------------------
AA 4% 15%
------------------------------------------------------------------------
A 8% 20%
------------------------------------------------------------------------
BBB 16% 40%
------------------------------------------------------------------------
Unrated/Below BBB \1\ 100% 100%
------------------------------------------------------------------------
\1\ Unrated, unsubordinated obligations issued by government sponsored
enterprises other than the reporting Enterprise are treated as AAA.
Unrated seller/servicers are treated as BBB. Other unrated
counterparties and securities are subject to a 100% haircut applied in
the first month of the stress test, unless OFHEO specifies another
treatment, on a showing by an Enterprise that a different treatment is
warranted.
Because the stress test does not model currency exchange rates
through the stress period, the stress test reflects the associated risk
by modeling the debt and the swap as a single debt transaction that
pays the dollar-denominated net interest rate paid by the Enterprise,
and no haircut is applied.
F. Cash Flows
For each month of the stress period, the stress test calculates
cash flows for every loan group and individual instrument reported in
the RBC Report and applies the haircuts to cash flows to reflect the
credit risk of securities and counterparties. These cash flows are used
to create pro forma financial statements that reflect an Enterprise's
total capital in each month of the stress period.
1. Mortgage Cash Flows
The cash flow component of the stress test applies projected
default, prepayment, and loss severity rates net of credit enhancements
to amortized loan group balances to produce mortgage cash flows for
each month of the stress period. Cash flows are generated for each
single family and multifamily loan group. For retained loan groups,
cash flows consist of scheduled principal, prepaid principal, defaulted
principal, credit losses, and interest. For sold loans, cash flows
consist of credit losses, guarantee fee income, and float income.
2. Mortgage-Related Security Cash Flows
Because losses on sold loans are absorbed by the Enterprises
directly and are not passed through to security holders, no additional
credit losses are
[[Page 47736]]
reflected in cash flows calculated for an Enterprise's own mortgage-
backed securities (MBSs) held as investments. Cash flows for single-
class MBSs issued by an Enterprise and held as investments consist only
of principal and interest payments. Cash flows for mortgage securities
not issued by the Enterprise consist of principal and interest payments
and credit losses based on haircuts according to rating level.
Principal payments are calculated by applying default and prepayment
rates that are appropriate for the loans underlying the MBS. The stress
test specifies that defaulted and prepaid principal and scheduled
amortization are passed through to investors. Interest is computed by
multiplying the security principal balance by the coupon rate.
Multiclass mortgage securities such as Real Estate Mortgage
Investment Conduit securities (REMICs) and stripped MBS (strips) are
treated in the same manner as single class MBS. The stress test
generates cash flows for the underlying collateral, usually single-
class MBSs, and applies the cash flow allocation rules of the
particular multiclass security to determine cash flows of the specific
class(es) held by an Enterprise. In generating cash flows for mortgage-
linked derivative contracts, where the notional amount of the contract
is based on the declining principal balance of a specified MBS, the
stress test applies the terms of each contract and tracks the
appropriate changing balances. The stress test generates cash flows for
mortgage revenue bonds by treating each bond as a single-class MBS
backed by 30-year, fixed-rate single family mortgages maturing on the
bond's stated maturity date.
3. Nonmortgage Instrument Cash Flows
The stress test calculates cash flows for securities that the
Enterprises hold as assets, or have issued as liabilities. The stress
test also generates cash flows for derivative instruments such as
interest rate swaps, caps, and floors. For nonmortgage investments,
outstanding debt securities, and liability-linked derivative contracts,
payments of principal and interest are calculated for each instrument
based on contractual terms and stress test interest rates. For fixed-
rate asset-backed securities, the stress test applies a 3.5 percent
collateral prepayment speed; for floating-rate securities a two percent
speed is applied in both interest rate scenarios.
For each month during the stress period that a security is subject
to early redemption (put/call), the stress test calculates the
effective remaining yield-to-maturity \28\ of that instrument and
compares it to the yield of a replacement security, under the given
stress period interest rate scenario. If the yield on the replacement
instrument is more than 50 basis points below the cost of the existing
instrument, the call or cancellation option is exercised. The stress
test applies a similar rule to derivative contracts that are subject to
cancellation.
---------------------------------------------------------------------------
\28\ Yields are calculated based on the outstanding principal
balances for securities and notional amounts for derivative
contracts.
---------------------------------------------------------------------------
G. New Products or Activities
Given the continuing evolution and innovation in the financial
markets, OFHEO recognizes that the Enterprises will continue to develop
and purchase new products and instruments and engage in other new
activities. To the extent that the current stress test treatments are
not applicable directly, OFHEO will combine and adapt current stress
test treatments in an appropriate manner in order to ensure that the
risks of these activities are adequately captured in the risk-based
capital requirement. For example, OFHEO might employ the mortgage
performance models and adapt its cash flow components to simulate
accurately the loss mitigating effects of credit derivatives. Where
there is no reasonable approach using existing combinations or
adaptations, the stress test will employ an appropriately conservative
treatment, consistent with OFHEO's role as a safety and soundness
regulator. Similarly, the Director has discretion to treat an existing
instrument as a new activity if OFHEO determines there have been
significant increases in volume that change the potential magnitude of
the risk of the instrument, or where other information indicates that
the risk characteristics of the instrument are not appropriately
reflected in a treatment previously applied.
An Enterprise that has a new activity is encouraged to suggest a
treatment which will be considered by OFHEO. The Enterprise will also
be able to comment on OFHEO's treatment before it is used for a final
capital classification. The public will have a subsequent opportunity
to submit views on these treatments, which will be considered for
future stress test applications.
H. Other Off-Balance-Sheet Guarantees
In addition to guaranteeing mortgage-backed securities they issue
as part of their main business, the Enterprises occasionally provide
guarantees for other mortgage-related securities to enhance the
liquidity and appeal of these securities in the marketplace. These
securities, notably single family and multifamily whole-loan REMIC \29\
securities and tax-exempt multifamily housing bonds, represent a small
part of the Enterprises' businesses and have a significant level of
credit enhancement that protects the Enterprises from losses.
Consequently, the stress test does not explicitly model the performance
of these securities, but uses an alternative modeling treatment. As a
proxy for the present value of net losses on these guarantees during
the stress period, the outstanding balance of these instruments at the
beginning of the stress period is multiplied by 45 basis points. The
resulting amount is subtracted from the lowest discounted monthly
capital balance for the calculation of stress test capital, as
described below in II.K., Calculation of the Risk-based Capital
Requirement.
---------------------------------------------------------------------------
\29\ Real Estate Mortgage Investment Conduit (REMIC) securities
are multiclass mortgage passthrough securities. The classes of a
REMIC security can take on a wide variety of attributes with regard
to payment of principal and interest, cashflow timing, (un)certainty
and maturity, among others.
---------------------------------------------------------------------------
I. Alternative Modeling Treatments
The stress test also assigns alternative modeling treatments to any
items for which data are incomplete, and any on- or off-balance sheet
items for which there is neither a specified treatment in the final
regulation nor a computationally equivalent proxy. An alternative
modeling treatment is a series of rules that assigns simple,
appropriately conservative assumptions, based on the interest rate
scenario, to an asset, liability, or off-balance-sheet item in the
stress test. Missing data elements are assigned a conservative default
value. This treatment will only be needed for extremely unusual items
or when all the necessary data for modeling an instrument are not
included in the RBC Report.
J. Enterprise Operations, Taxes and Accounting
The stress test simulates the issuance of new debt or purchase of
new investments, exercise of options to retire debt early or cancel
derivative contracts, payment of dividends by the Enterprises,
operating expenses, and income taxes. The stress test computes Federal
income taxes using an effective tax rate of 30 percent. Estimated
income tax is paid by the Enterprises quarterly in the stress test.
When necessary, the stress test simulates the issuance of new debt
or
[[Page 47737]]
purchase of new investments by an Enterprise. A mix of short- and long-
term debt is issued in months when there is a shortfall of cash. New
short-term debt is six-month discount notes at the simulated Enterprise
Cost of Funds. New long-term debt is five-year debt, callable after the
first year, at the five-year Enterprise Cost of Funds, plus a 50 basis-
point premium for the call option. Short- and long-term debt issuance
is targeted to achieve and maintain a total liability mix of 50 percent
short-term debt and 50 percent long-term debt. Excess cash is invested
in one-month securities bearing the six-month Treasury rate.
Capital distributions are made during the stress period. If an
Enterprise's core capital \30\ exceeds the minimum capital requirement
in any quarter, dividends on preferred stock are paid based on the
coupon rates of the issues outstanding. Common stock dividends are paid
only in the first four quarters of the stress period. The amount paid
is directly related to the earnings trend of the Enterprise. Generally,
if the trend is positive, the dividend payout ratio is the same as the
average of the four quarters preceding the stress test. Otherwise,
dividends are based on the dollar amount per share paid in the last
quarter preceding the stress test. Share repurchases are made in the
first two quarters of the stress period, based on the average stock
repurchase for the four quarters preceding the stress test. No capital
distribution is made if core capital is below the minimum capital
requirement. If a capital distribution would cause core capital to fall
below the minimum capital requirement, the distribution is made only to
the extent of the core capital that exceeds the minimum capital
requirement.
---------------------------------------------------------------------------
\30\ Core capital, as defined at 12 U.S.C. 4502(4) consists of
par value or stated value of outstanding common, and perpetual,
noncumulative, preferred stock, paid-in capital, and retained
earnings, determined in accordance with Generally Accepted
Accounting Principles.
---------------------------------------------------------------------------
Operating expenses decline during the stress test as the
Enterprise's mortgage portfolios decline, but the decline is not
strictly proportional. The baseline level from which they decline is
the average monthly operating expenses of the Enterprise for the three
months preceding the start of the stress test. In each month of the
stress test, the amount of the decline is determined by computing a
base amount comprised of a fixed component and a variable component.
The fixed component is one third of the baseline level, and the
variable component begins as the remaining two thirds of the baseline
level and declines in direct proportion to the decline in the UPB of
the combined portfolios of retained and sold loans during the stress
period. The base amount is further reduced by one-third, except that
this further reduction is gradually phased in during the first 12
months of the stress test.
To the extent possible, the stress test makes use of Generally
Accepted Accounting Principles (GAAP). However, the stress test does
not reflect certain securities and derivatives at their fair value, as
required by the Financial Accounting Standards Board's Statement of
Financial Accounting Standard (FAS) Nos. 115 and 133. In the first
month of the stress test, these assets are adjusted to an amortized
cost basis.
K. Calculation of the Risk-Based Capital Requirement
The stress test determines the amount of capital that an Enterprise
must hold at the start date in order to maintain positive capital
throughout the ten-year stress period (stress test capital). Once
stress test capital has been calculated, an additional 30 percent is
added to protect against management and operations risk. This total is
the risk-based capital requirement.
In order to calculate stress test capital, the capital balance for
each month is discounted back to the start of the stress period, using
capital as calculated in the pro forma financial statements and
interest rates for both stress test scenarios. The stress test uses the
six-month Treasury rate when the Enterprise is a net lender and the
six-month Enterprise Cost of Funds when the Enterprise is a net
borrower. The lowest discounted monthly capital balance is then
decreased as described above to account for certain items given
alternative modeling treatments, including the other off-balance-sheet
obligations described above in II.H., Other Off-Balance-Sheet
Guarantees. This lowest discounted monthly balance, if positive,
represents a surplus of initial capital, that is, capital that was not
``used'' during the stress period. If negative, it represents a deficit
of initial capital. The lowest discounted monthly balance is then
subtracted from the Enterprise's initial capital. The resulting amount
is the smallest amount of starting capital required to maintain
positive capital throughout the stress period.
For example, if an Enterprise holds starting capital of $10 billion
and the lowest discounted monthly balance is $1 billion (representing a
positive capital balance in the worst month of the stress period), then
the amount of starting capital necessary to maintain positive capital
throughout the stress period is $9.0 billion. If, on the other hand,
the lowest discounted monthly balance is -$1 billion (representing a
negative capital balance in the worst month), the necessary starting
capital to maintain positive capital throughout the stress period is
$11.0 billion.
Finally, required starting capital is multiplied by 1.3 to complete
the calculation of the risk-based capital requirement required by the
1992 Act.
III. Comments and Responses
The final rule reflects OFHEO's consideration of all the comments
on NPR1 and NPR2, including responses from those commenters who replied
to the initial comments on NPR2. After careful review and analysis of
the comments, OFHEO determined that a number of recommendations had
merit. OFHEO accepted these recommendations and made changes in the
stress test accordingly. In other cases where commenters recommended
changes, OFHEO did not accept the specific suggestion, but modified the
stress test to address the commenters' concerns. Other recommendations
proved to be contrary to the 1992 Act, did not offer a better
alternative to the existing stress test, or had merit but required
further study before they could be implemented.
The commenters on NPR1 and NPR2 included the Enterprises, financial
services and housing-related trade associations, financial service
companies, affordable housing groups and agencies, a governmental
agency, a private rating agency and several individuals.
Trade associations commenting included American Bankers Association
(ABA), America's Community Bankers (ACB), Consumer Mortgage Coalition
(CMC), Mortgage Bankers Association of America (MBA), Mortgage
Insurance Companies of America (MICA), National Association of Home
Builders (NAHB), National Association of Realtors (NAR), Credit Union
National Association (CUNA), National Bankers Association (NBA),
National Association of Real Estate Brokers (NAREB), and National Home
Equity Mortgage Association (NHEMA).
Financial services companies commenting included GE Capital
Mortgage Corporation (GE Capital), Chase Manhattan Mortgage
Corporation, Charter One Bank, Goldman Sachs, Newport Mortgage Company
L.P., J.P. Morgan & Co. Incorporated, Bear Stearns & Co. Inc., Morgan
Stanley Dean Witter (Morgan Stanley), Lehman Brothers, Salomon Smith
Barney, Triad Guaranty Insurance Corporation, Merrill Lynch, Promentory
Financial Group LLC, PW
[[Page 47738]]
Funding Inc., Amresco Capital, L.P., Golden West Financial Corporation
(World Savings), Countrywide (Mid-America Bank FSB), American
International Group Inc. (AIG), the Federal Home Loan Bank of Chicago,
and WMF Group.
Affordable housing groups and agencies included The Enterprise
Foundation and the Local Initiatives Support Corporation, National
Center for Community Self Help, National Council of State Housing
Agencies (NCSHA), Association of Local Housing Finance Agencies,
Nebraska Investment Finance Authority, Neighborhood Housing Services of
America, Inc., National Association of Affordable Housing Lenders
(NAAHL), PT & Associates Community Development Consulting, National
Neighborhood Housing Network, National Community Reinvestment
Coalition, and Coalition on Homelessness & Housing in Ohio.
Other commenters included Office of Thrift Supervision, Fitch ICBA,
Nelson Yu, O'Melveny & Myers LLP, and L. William Seidman.
A summary of the comments and OFHEO's responses are set forth
below, by topic.
A. Approach
Commenters generally agreed on the basic premises underlying
OFHEO's proposal to implement a risk-based capital requirement for the
Enterprises: the importance to the nation's housing finance system of
financially strong Enterprises, and the appropriateness of the weight
the 1992 Act places on a risk-based capital requirement to protect the
Enterprises' capital adequacy. The views of commenters, however,
diverged on the question of whether a stress test, such as the one
proposed in NPR2, provided the best approach to setting a risk-based
capital requirement for the Enterprises. Among the commenters who
agreed that a stress test was the best approach, the views diverged on
the question of how the stress test should be implemented. The general
comments on OFHEO's approach are discussed below by topic.
1. Bank and Thrift Approach
a. Comments
Some commenters suggested that OFHEO take an overall approach to
capital regulation similar to that emerging among the bank and thrift
regulators and the Basel Committee on Banking Supervision. The
suggestions of these commenters included using ratios to set capital
requirements for credit risk and Value at Risk (VaR) methodologies for
market risk rather than a stress test. One Enterprise and one
commenter, however, noted that although VaR methodology is a valuable
analytical tool, it is not appropriate for determining risk-based
capital as prescribed by the 1992 Act.
The approach evolving in the bank regulatory community applies
ratios to categories of on- and off-balance-sheet items to derive
capital requirements, but also begins to incorporate VaR and other
methodologies that financial institutions employ in their proprietary
models. The approach, which is outlined in the June 1999 report by the
Basel Committee on Banking Supervision (Committee) titled ``A New
Capital Adequacy Framework,'' also puts more emphasis on supervisory
review and greater market discipline based on expanded disclosure of
risk. The June 1999 report discusses a new capital framework consisting
of three ``pillars'': minimum capital requirements, a supervisory
review process, and market discipline.
The three pillars approach to bank regulatory capital seeks to
improve the relationship of bank capital requirements to risk that was
set out in the 1988 Accord. The 1988 Accord was itself a major
departure from the simple leverage ratios applied by regulators to
total assets. It introduced a capital framework that applied ratios to
broad categories of assets according to their relative riskiness as
reflected by type of instrument (e.g., residential mortgages,
commercial loans, or lines of credit) or by obligor (e.g., sovereign
government, national bank, or industrial company). At the time the
Accord was introduced, the Committee recognized the limitations
inherent in quantifying credit risk by applying ratios to such broad
categories of assets. The Committee also recognized that credit risk
was only one element of the risk profile of a financial institution.
Subsequent enhancements, most notably permitting the use of proprietary
models to calculate a supplemental capital requirement reflecting the
market risk of a large financial institution's trading portfolio, have
continued to improve the process of quantifying risk and calculating an
appropriate level of capital based on risk.
In January of 2001, the Committee published for comment a proposal
embodying the three pillars to replace the 1988 Accord.\31\ The
proposal is intended to be a more risk-sensitive framework containing a
range of new options for measuring both credit and operational risk.
Key elements of the proposal were a refinement of the minimum capital
requirement to make it more risk-sensitive, a greater emphasis on the
bank's own assessment of its risk, and a decision to treat interest
rate risk under the second pillar, the supervisory review process.The
proposal described a ``foundation'' or standardized approach to credit
risk, which was a refinement of the 1988 approach to minimum capital,
and an ``advanced'' internal ratings-based approach for banks that meet
more rigorous supervisory standards. The latter made use of internal
estimates, subject to supervisory review, but stopped short of
permitting banks to calculate their capital requirements on the basis
of their own portfolio credit risk models. Separate disclosure
requirements were set forth as prerequisites for supervisory
recognition of internal methodologies for credit risk, credit risk
mitigation techniques, and asset securitization. The Committee
indicated that similar disclosure prerequisites would attach to the use
of advanced approaches to operational risk.
---------------------------------------------------------------------------
\31\ Committee on Banking Supervision, ``Overview of the New
Basel Capital Accord,'' Bank for International Settlements, Basel,
Switzerland (January 2001). A copy of this document can be obtained
from the BIS website at http://www.bis.org.
---------------------------------------------------------------------------
After reviewing the comments on the January 2001 proposal, the
Committee announced in June of 2001 that the proposal needs further
adjustment to maintain equivalency between the two approaches and to
ensure that the capital incentives are appropriate to encourage banks
to adopt the more advanced approaches.\32\ The Committee reaffirmed its
support for the three pillars approach and announced that it would
release a complete and fully specified proposal for an additional round
of consultation in early 2002, with a target implementation date of
2005.
---------------------------------------------------------------------------
\32\ See press release of June 25, 2001, ``Update of the New
Basel Accord.'' A copy of this document may be obtained on the BIS
website at http://www.bis.org.
---------------------------------------------------------------------------
b. OFHEO's Response
Although the 1992 Act requires a risk-based capital standard for
the Enterprises that is based on a stress test, OFHEO's overall
approach to regulation is broadly parallel to the three pillars
approach proposed by the Committee. OFHEO already pursues a
``multidimensional'' approach to regulating the Enterprises' capital,
as one commenter urged. OFHEO's minimum and risk-based capital
requirements are quantifiable capital requirements, which are the goals
of the Committee's first pillar; OFHEO employs risk-based examination
and
[[Page 47739]]
oversight of the Enterprises that provides the type of oversight
contemplated in the second pillar; and OFHEO is currently reviewing the
Enterprises' public disclosures to determine whether they would provide
an adequate basis for market discipline as contemplated in the third
pillar.
Although OFHEO will follow with interest the Committee's progress
in developing a new regulatory capital framework and, where
appropriate, consider incorporating aspects of this new framework into
its regulation of the Enterprises, OFHEO believes that its stress test
is appropriate to implement the statutory requirements and ties capital
more closely to risk than either the current Basel Accord or recent
proposals. The current capital adequacy regime for large banks
quantifies credit risk by applying ratios to risk-weighted asset and
off-balance-sheet amounts and quantifies market risk only to the extent
of the interest rate risk in the banks' trading portfolios. In refining
the treatment of credit risk, the Committee's three pillars approach
would continue to rely on ratios. Interest rate risk would be addressed
under the second pillar, the supervisory review process. By contrast,
OFHEO's stress test simultaneously captures credit risk and interest
rate risk of an Enterprise's entire business.
OFHEO also believes that VaR methodologies that large banks use to
evaluate the interest rate risk of their trading portfolios are not
adequate to implement the requirements of the 1992 Act. VaR approaches
are best used to evaluate risk over relatively short time periods and
are, therefore, appropriate for evaluating trading portfolios. The
Enterprises' asset portfolios, however, are not a ``trading book,'' as
one commenter suggested. Rather, these portfolios are comprised largely
of assets that are held to maturity. The Enterprises' actual trading
portfolios are, in fact, a small part of the Enterprises' balance
sheets. Further, although large banks continue to use VaR models for
calculating day-to-day trading risk, since the disruptions in the
global financial markets in 1997 and 1998, these banks increasingly
have employed stress tests to measure their market exposure.\33\ These
banks found that VaR models were less able to measure risk under
extreme market conditions than stress tests.
---------------------------------------------------------------------------
\33\ Committee on the Global Financial System, ``Stress Testing
by Large Financial Institutions: Current Practice and Aggregation
Issues,'' 14 Bank for International Settlements, Basel, Switzerland
(April 8, 2000). A copy of this document may be obtained from the
BIS website at http://www.bis.org.
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2. Proprietary/Internal Models
a. Comments
Some of the commenters who recommended the bank and thrift
regulatory approach urged that OFHEO permit the Enterprises to use
their proprietary models to determine interest rate risk. A number of
other commenters contended that each Enterprise should calculate its
own risk-based capital requirement using a stress test model specified
by OFHEO but developed by the Enterprise. Each Enterprise would then
report its risk-based capital requirement to OFHEO in the same manner
as the minimum capital requirement is reported. All of these commenters
suggested that OFHEO could ensure the integrity of the capital
calculation process through its examination function. In arguing for
the use of internal models, one commenter also noted that the risk-
based capital proposals of the Farm Credit Administration (FCA) and the
Federal Housing Finance Board (FHFB) also permit the use of proprietary
and/or internal models to varying degrees.
Both Enterprises agreed that they should calculate their own risk-
based capital requirement, contending that it is sufficient for OFHEO
to publish the specifications for the model. They recommended that they
should run the stress test as specified by OFHEO on their own internal
systems, at least as a transitional measure. The Enterprises believe
this would be the fastest and most efficient way to implement a risk-
based capital rule that would produce capital numbers in a timely way.
Other commenters believed that allowing an Enterprise to calculate
its own capital requirement using its proprietary models or a model
that OFHEO specifies would undermine OFHEO's regulatory independence
and impede the transparency of the stress test for third parties. These
commenters felt that OFHEO must retain control of both the model and
the process for determining the Enterprises' risk-based capital
requirements to ensure the integrity of the calculation of risk-based
capital.
The Congress has required FCA, which regulates the Federal
Agricultural Mortgage Corporation (Farmer Mac), and FHFB, which
regulates the Federal Home Loan Banks, to establish risk-based capital
standards for the entities they regulate. The statutory requirements
for FCA's risk-based capital regulation,\34\ which parallel the
requirements of the 1992 Act, include a ten-year stress test, a worse-
case historical credit loss experience, and stressful interest rate
scenarios. The FCA rule specifies the basic structure and parameters of
the risk-based capital stress test and allows Farmer Mac to use FCA's
spread sheet model or implement the stress test using an internal model
built to FCA's specifications to determine its risk-based capital
requirement.\35\
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\34\ 66 FR 19048, April 12, 2001. FCA's rule determines
stressful credit conditions by applying loss frequency and severity
equations to Farmer Mac's loan-level data. From these equations,
FCA's test calculates loan losses, assuming Farmer Mac's portfolio
remains at a ``steady state,'' and allocates the calculated losses
to each of the ten years. Interest rate risk is quantified using the
results of Farmer Mac's interest rate risk shock-test to determine
the change in the market value of equity (MVE). The change in MVE is
posted to the first period in the stress test.
\35\ In its notice of proposed rulemaking, FCA noted ``that
because of the proprietary nature of specific, transaction loan
level 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, however,
will be able to approximate the test results on an aggregate basis
using publicly available information.'' 64 FR 61741, November 12,
1999.
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The statutory requirements for FHFB's recently adopted capital
regulation,\36\ which takes an approach similar to that of the bank and
thrift regulators, are much less specific than either OFHEO's or FCA's,
but direct FHFB to take OFHEO's stress test into consideration. In the
FHFB rule, each Federal Home Loan Bank calculates its own risk-based
capital charge.\37\
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\36\ 12 FR 8262, Jan. 30, 2001; 12 CFR parts 915, 917, 925, 930,
931, 932, 933, 956, and 960.
\37\ Capital to cover credit risk is calculated from leverage
ratios that are based upon the credit ratings of counterparties and
collateral supporting the credit. 66 FR 8313 (Jan. 30, 2001). Market
risk capital is based on internal VaR models or stress tests and a
determination of the amount by which the current market value of a
Federal Home Loan Bank's total capital is less than 85 percent of
the book value of total capital. Id. at 8317. Capital for operations
risk is 30 percent of credit risk capital, although the FHFB may
approve a lesser amount (not less than 10 percent) where the Federal
Home Loan Bank obtains appropriate insurance or provides an
acceptable alternative method for assessing and quantifying
operations risk capital. Id. at 8318.
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b. OFHEO's Response
The final rule continues to provide for capital classifications to
be determined based on a stress test specified, developed, and
administered by OFHEO. OFHEO believes this approach best fulfills the
statutory purposes and maintains the integrity of the risk-based
capital regulation. Allowing the Enterprises to use their proprietary
models or models they develop based
[[Page 47740]]
on OFHEO's specifications to calculate their own capital requirements
could result in a weaker and inconsistently applied standard. However,
each Enterprise will receive the source code for the stress test, which
will enable it to compute its own capital requirement for internal
purposes and to comment on its proposed capital classification.
Although FCA's statutory framework is similar to the 1992 Act,
statutory interpretations that are appropriate for FCA's statute are
not necessarily appropriate interpretations of the 1992 Act, and
differences in regulatory responsibilities make the FCA approach
unworkable for OFHEO. FCA is charged with developing a stress test for
a single entity, while OFHEO regulates two entities, both of which must
be subject to the same stress test.\38\ Models that the Enterprises
develop themselves would inevitably differ in their details, which
could result in significant variations, and make it difficult to apply
the stress test consistently to both Enterprises. In addition, the 1992
Act requires that the stress test be set forth in a regulation subject
to notice and comment rulemaking,\39\ that the risk-based capital
regulation be sufficiently specific to permit someone other than the
Director to apply the test,\40\ and that OFHEO make the stress test
model publicly available.\41\ For these reasons, OFHEO concluded that
the most practical way to comply with these statutory provisions was to
develop and administer its own model on its own systems and apply the
stress test even-handedly to both Enterprises.
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\38\ See 12 U.S.C. 4611(a) (``The Director shall, by regulation,
establish a risk-based capital test for the Enterprises. When
applied to an Enterprise, the risk-based capital test shall
determine the amount of total capital for the Enterprise * * *'')
(emphasis added). See also H.R. Rep. No. 102-206 at 62 (1991).
``Beyond these traditional capital ratios, the bill sets forth
guidelines for the creation, in highly specific regulations, of a
risk-based capital standard * * * The model, or stress test, will
generate a number for each Enterprise, which will become the risk-
based standard for that Enterprise.'') (emphasis added).
\39\ 12 U.S.C. 4611(e)(1).
\40\ 12 U.S.C. 4611(e)(2).
\41\ 12 U.S.C. 4611(f).
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Use of the FHFB approach is not viable for OFHEO under the 1992
Act, which requires a specific stress test, and does not provide the
option of allowing each institution to design an appropriate risk-based
capital test. The FHFB compared the agencies' approaches in the
preamble to its final rule, noting that ``[f]or example, the GLB Act
requires that the [FHFB] develop a stress test that rigorously tests
for changes in interest rates, interest rate volatility and changes in
the shape of the yield curve, while the statutory requirements
governing Fannie Mae and Freddie Mac set forth specific scenarios for
downward and upward shocks in interest rates.'' \42\ Other examples of
statutory differences include the requirement in the 1992 Act that
credit losses be related to the benchmark loss experience and an
extensive list of factors that OFHEO must consider in designing the
stress test. Further, the procedural requirements that the details of
the stress test be published by regulation and made available to the
public also make an internal models approach impractical for OFHEO.
---------------------------------------------------------------------------
\42\ 66 FR at 8283.
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OFHEO also finds that regulatory independence and rigor is best
served by OFHEO's approach. The availability of the stress test on
OFHEO's systems allows OFHEO greater flexibility to run the stress test
whenever it may be needed. Maintaining the infrastructure to support
the stress test also gives OFHEO the ability to independently test
alternative risk scenarios in addition to the two stress test
scenarios, which ensures the integrity of the stress test. This
capability will also permit OFHEO to test possible improvements and
adjustments to the stress test.
In sum, OFHEO concurs with the concerns of the commenters who
recommended that OFHEO develop and maintain a single stress test model
and require the Enterprises to provide the necessary data for the
stress test. The Enterprises certainly may replicate that model from
OFHEO's model specifications and computer code and use it to determine
the capital impact of various business decisions. For the purposes of
determining the capital classifications, however, OFHEO will run its
own model using data submitted by the Enterprises. To alleviate some of
the Enterprises' concern about the ability of the model to produce
accurate capital numbers in a timely way, the final regulation
establishes a standardized data reporting format for the RBC Report.
This Report will enable OFHEO to produce capital numbers within the
regulatory time frame. See sections III.B., Operational Workability of
the Regulation and III.E., Enterprise Data.
3. Mark to Market for ``Tail Risk''
a. Comments
Two commenters said that OFHEO should consider losses beyond the
end of the stress test period, either by marking to market remaining
positions or otherwise requiring additional capital to cover the risk
that remained at the end of the ten-year stress period. One Enterprise
responded that marking to market to capture this ``tail risk'' would be
contrary to the 1992 Act.
b. OFHEO's Response
The final regulation does not adopt the commenters' suggestions to
require capital for on- and off-balance-sheet items that remain at the
end of the ten-year stress period or to mark these items to their
market value. The 1992 Act specifies that the stress period is ten
years and that total capital must meet or exceed the amount of capital
necessary to survive the stress period with positive capital. Marking
to market balance sheet items that remain at the end of the 120 month
period would bring into the stress test period earnings or losses
beyond the ten-year period and would be inconsistent with the 1992 Act.
4. Additional Interest Rate Scenarios
a. Comments
Several commenters suggested that OFHEO study additional interest
rate scenarios to ensure that smaller changes in interest rates do not
result in risk-based capital requirements that are larger than the
requirements generated by the interest rate scenarios in the 1992 Act.
These commenters expressed concern that the risk-based capital rule
will be inadequate unless OFHEO runs more than two interest rate
scenarios. They also urged OFHEO to monitor any attempts by the
Enterprises to take advantage of the limited number of interest rate
scenarios in the stress test. The comment implies, for example, that an
Enterprise could enter into inexpensive interest rate derivatives
contracts that would allow the Enterprise to easily pass the two
interest rate scenarios of the stress test. Under slightly different
and possibly less stressful interest rate scenarios, these derivatives
might be useless, but a stress test based on only two interest rate
scenarios would not uncover this deficiency. To prevent this problem,
the commenters said that OFHEO should run additional scenarios with a
variety of assumptions, including combinations of smaller interest rate
changes, more volatile interest rates, different yield curves, and
alternative changes in house prices. They recommended that OFHEO set
the risk-based capital requirement for an Enterprise at the highest
amount generated by any additional scenarios. One Enterprise disagreed,
saying that more moderate interest rate movements would probably result
in lower capital requirements. The Enterprise also noted that OFHEO's
examination process
[[Page 47741]]
ensures the integrity of Enterprises' risk management process.
b. OFHEO's Response
In response to these comments, OFHEO notes that the 1992 Act
provides only two scenarios for the stress test and requires that risk-
based capital be based on whichever of the two scenarios results in the
higher capital requirement. Although OFHEO intends to run additional
scenarios in order to monitor an Enterprise's capital adequacy, OFHEO
does not need to modify the regulation to include scenarios beyond
those specifically required in the 1992 Act. Moreover, it is not clear
that specifying additional scenarios in the risk-based capital
regulation would address the concerns of the commenters. If OFHEO were
to add scenarios to the final rule, an Enterprise could simply enter
into additional derivatives contracts that would hedge the new
scenarios.
The 1992 Act specifies two interest rate scenarios, but it does not
prohibit the running of additional scenarios as part of OFHEO's on-
going monitoring of safety and soundness of the Enterprises. OFHEO can
only test how well the results of the statutory scenarios reflect risk
if OFHEO continues to run additional scenarios based on market
conditions and other factors the Director considers appropriate. Should
OFHEO discover any capital weakness when it runs additional scenarios,
OFHEO has supervisory tools available to correct the situation. For
example, if additional stress testing reveals that scenarios equally or
less stressful than those in the 1992 Act would cause an Enterprise to
fail the stress test, the Director may determine that grounds for
discretionary capital reclassification exist under section 1364(b) of
the 1992 Act. Similarly, a finding by the Director that an Enterprise
is conducting itself in a way that threatens to cause a significant
depletion of core capital would provide grounds for a cease and desist
order.
B. Operational Workability of the Regulation
A broad theme of the comments was that OFHEO should move
expeditiously to a final rule that is operationally workable. By
operationally workable, most commenters meant that the regulation must
provide for accurate and timely calculations of risk-based capital
requirements. From a regulatory perspective, OFHEO agrees, because the
risk-based capital requirement, together with the minimum capital
requirement, serves as the basis for classifying the Enterprises as
``adequately capitalized'' or ``undercapitalized.'' OFHEO must
determine these classifications as quickly as possible to minimize
delays in identifying capital shortfalls. However, a number of
commenters also expressed more specific concerns related to how the
rule and the stress test that underlies it will operate in practice.
These comments and OFHEO's responses to them are explained below.
1. Replicability and Transparency
To the Enterprises and some other commenters, the concept of
operational workability meant that the stress test should be
sufficiently transparent that the Enterprises can use it for internal
planning and analysis. This level of transparency would allow the
Enterprises to calculate capital numbers on their own systems with
reasonable assurance that the results will closely mirror OFHEO's
results. To certain non-Enterprise commenters, however, the concept of
transparency meant complete replicability of OFHEO's results--that is,
the ability of parties other than OFHEO and the Enterprises to run the
stress test and to evaluate the potential impacts on Enterprise
regulatory capital requirements of changes in the economy or Enterprise
business mix. These commenters asserted that in order to promote market
discipline, the stress test should be this transparent to third
parties. They recommended that OFHEO release the computer code as well
as the complete specifications of the stress test. A few commenters
stated that the stress test could not be completely transparent without
the release of Enterprise data, some of which may be proprietary.
OFHEO strongly supports a concept of operational workability that
allows capital classifications to be determined in a timely manner,
allows the Enterprises to use the stress test as a planning tool, is
transparent to third parties, and allows capital classifications to be
calculated in a timely manner. To this end, OFHEO, working with the
Enterprises, has developed a standardized reporting format, the RBC
Report, that will permit the reported data to be input into the stress
test without manipulation and will work with the Enterprises to assist
them in aligning their data systems with the reporting format so that
they will be able to run the stress test on their systems and achieve
the same result as the Director. This will permit timely
classifications and will permit the Enterprises to anticipate what
their capital classification will be. OFHEO's treatment of new
activities, discussed below in III.B.3., New Enterprise Activities, is
also designed to allow the Enterprises to understand the probable
impact of new activities on their regulatory capital requirements. In
addition, OFHEO will release to the Enterprises and other requesting
parties a copy of the computer code. A stylized data set also will be
made available to interested parties to permit them to understand the
sensitivities and implications of the stress test.\43\ This information
will allow parties other than OFHEO to apply the stress test to any set
of starting data in the same manner as OFHEO.
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\43\ The stylized data set will include a realistic mix of on-
and off-balance sheet items of a hypothetical Enterprise. It will
allow any interested party to run the test, to vary the mix of
items, add or delete items, change starting interest rates, modify
historical house price patterns, and understand potential impacts of
these actions or events upon Enterprise capital.
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OFHEO disagrees, however, with commenters who suggest that third
parties should be provided the actual starting position data that are
input to the stress test. These data include Enterprise information
that is not public and may be subject to legal prohibitions or
restrictions on disclosure or may otherwise unfairly disadvantage an
Enterprise if disclosed. Given the statutory protections for
proprietary data included in the 1992 Act and elsewhere,\44\ OFHEO
believes that the requirement of the 1992 Act that others be able to
apply the test in the same manner as the Director should not be read to
require the release of proprietary data. OFHEO anticipates that the
information it is supplying to the public about the model meets this
statutory requirement and provides interested parties with a solid
understanding of the interaction in the model of credit and interest
rate stresses and an ability to understand the capital implications of
changes in an Enterprise's risk profile. OFHEO strongly favors
promoting market discipline. Because of the forward-looking nature of
the stress test, OFHEO's periodic publication of the current capital
numbers together with current capital classifications will promote such
discipline.
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\44\ See, e.g., 12 U.S.C. 4611(e)(3); 18 U.S.C. 1905.
---------------------------------------------------------------------------
2. Predictability v. Flexibility
The comments suggest that in order for the stress test to be useful
to the Enterprises in their businesses, its results must be
sufficiently predictable to permit it to be used as a planning tool,
while sufficiently flexible to take into account new products or other
innovations by the Enterprises. From these somewhat competing
considerations flowed a range of comments concerning the frequency with
which OFHEO should amend the
[[Page 47742]]
regulation, the process that would be followed for changing the
regulation, and the treatment of new activities and instruments, i.e.,
those for which the stress test does not currently prescribe a
treatment.
Some commenters suggested that the final rule specify a process for
routine updating of the stress test to incorporate industry
improvements in risk management techniques. One commenter recommended
specifying a threshold, expressed as a percentage of the minimum
capital requirement, that would determine when changes require notice
and comment. For changes that would not reach the threshold, the
commenter recommended specifying a one-year implementation period and
for changes that are proposed for notice and comment, a two-year
period. Other commenters, including Fannie Mae, recommended severely
limiting changes to create ``stability'' in the stress test. Freddie
Mac recommended that OFHEO affirm that it would follow the
Administrative Procedure Act (APA) when changes are made to the final
regulation.
The final rule balances the concern for stability with the concern
for flexibility, recognizing that the nature of the Congressional
mandate and the dynamic nature of the Enterprises' businesses will
require an ongoing assessment of how well the stress test achieves its
objectives. To achieve its statutory objective of aligning capital to
risk, the stress test necessarily must evolve as the risk
characteristics of new and complex instruments and activities become
better understood and modeling techniques more highly developed.
Therefore, OFHEO cannot eliminate uncertainty about how the stress test
might evolve without reducing the sensitivity of the stress test to
risk. Sufficient discretion must be retained by the Director to respond
to innovations as they occur. And yet, in its important particulars,
there must be enough stability in the stress test to allow the
Enterprises and others to predict with reasonable confidence the impact
that changes in their business plans or the economy may have on their
capital requirements.
OFHEO will continue to monitor and study changes in the
Enterprises' businesses and the markets in which they operate. OFHEO
also will evaluate new statistical data that become available to
determine whether they have implications for Enterprise risks. These
continuing efforts will, doubtlessly, suggest reestimation of the
models and other changes to the stress test from time to time. However,
OFHEO does not find it appropriate at this time to specify a process,
beyond the APA, for routine updating of the rule or to commit in
advance to limiting the size or frequency of changes to the rule. Only
after the rule has been operational for a significant period of time
can OFHEO assess whether there is a need for further rulemaking to
specify a change process. In any event, OFHEO affirms that any future
amendments to the regulation will comply with the APA.
3. New Enterprise Activities
a. Proposed Rule
Section 1750.21 of the proposed regulation and section 3.11 of the
Proposed Regulation Appendix together were designed to implement the
substantive risk-based capital requirements of the 1992 Act,\45\ the
notice and comment requirements of the APA,\46\ and the replicability
and public availability requirements of sections 1361(e) and (f) of the
1992 Act.\47\ The quarterly capital calculations required by the 1992
Act \48\ must, as accurately and completely as possible, capture the
risks in the portfolio of each Enterprise. The requirement that
classifications be done on not less than a quarterly basis is designed
to ensure that changes in the risk profile of an Enterprise are
captured frequently and reasonably close in time to when they are
reflected on an Enterprise's books.
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\45\ 12 U.S.C. 4614, 4618.
\46\ 5 U.S.C. 553.
\47\ 12 U.S.C. 4611(e), (f).
\48\ 12 U.S.C. 4614(c).
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Given the dynamics of the marketplace and the Enterprises'
business, it is not possible to construct a regulation that specifies a
detailed model that could predict every new type of instrument or
capture every new type of risk that might emerge from quarter to
quarter. Therefore, to comply with the requirements of the 1992 Act,
the proposed regulation included a provision, section 3.11 of the
proposed Regulation Appendix, to address future instruments and
activities, thus enabling each quarterly capital classification to be
as accurate as possible. Section 3.11, together with other provisions
in the regulation, was intended to help achieve that accuracy.
More specifically, section 3.11 of the proposed Regulation Appendix
provided that the credit and interest rate risk of new activities and
instruments would be reflected in the stress test by simulating their
credit and cash flow characteristics using approaches already described
in the Appendix. To the extent those approaches were not applicable
directly, OFHEO proposed to combine and adapt them in an appropriate
manner to capture the risk in the instruments. Where there is no
reasonable approach using combinations or adaptations of existing
approaches, the proposed stress test would employ an appropriately
conservative treatment, which would continue until such time as
additional information is available that would warrant a change to the
treatment.
In addition to the substantive provisions of section 3.11 of the
proposed Regulation Appendix, procedures were proposed in that section
and in section 1750.21 of the regulation that would give the Enterprise
involved advance notice of the treatment to be implemented and an
opportunity to comment on it before it is implemented. Procedurally,
proposed section 3.11 provided that an Enterprise should notify OFHEO
of any pending proposal related to new products, investments, or
instruments before they are purchased or sold or as soon thereafter as
possible. The procedures in the proposed rule were also intended to
encourage the Enterprise to provide OFHEO with any suggestions it may
have as to an appropriate risk-based capital treatment for the activity
or instrument. With the benefit of the information provided by the
Enterprise, OFHEO would then notify the Enterprise of its estimate of
the capital treatment as soon as possible.
Beyond these provisions, proposed section 1750.21 provided that the
Enterprise would be notified of the proposed treatment when OFHEO
provided the quarterly Notice of Proposed Capital Classification. After
receiving that notice, the Enterprise would have thirty days to provide
further comments to OFHEO. Those comments would be considered by OFHEO
prior to issuing the final capital classification. Further, to ensure
that the rest of the public could apply the test in the same manner as
the Director, OFHEO planned to make the new treatment available to the
public through an appropriate medium, such as the Federal Register,
OFHEO's website, or otherwise. Comments from the public on these
notices would be considered by OFHEO. Taken together, all of these
provisions implement the procedural provisions of the 1992 Act and the
APA, while assuring that the timely, complete and accurate capital
classifications required by the 1992 Act are carried out.
b. Comments
Numerous comments addressed the capital treatment of new activities
proposed in section 3.11 of the Regulation Appendix in NPR2. These
[[Page 47743]]
comments all urged OFHEO to adopt a clearly understood procedure that
would be sufficiently flexible to allow the Enterprises to continue
introducing new products. They emphasized that delay and uncertainty
about treatments of new activities could frustrate introduction of
innovative new products and business lines at the Enterprises.
The Enterprises both recommended that the process for new
activities should allow them to understand as soon as possible the
effect on capital of any new types of products or instruments that they
introduce. Both Enterprises offered suggestions in the context of their
recommendation that the stress test be run using their own
infrastructures.\49\ Although these suggestions differed in their
details, both would allow the Enterprises to develop and implement
capital treatments for new activities, subject to subsequent review and
change by OFHEO.
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\49\ See III.A.2., Proprietary/Internal Models.
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Other commenters suggested that if OFHEO determined that a proposed
treatment for a particular new activity would have a minimal impact
upon total risk-based capital, that the treatment should be expedited
and that no notice and comment process should be required. Treatments
that would have a substantial impact on capital would be implemented
using notice and comment procedures under the APA. One commenter
suggested that a risk-based capital ``surcharge'' be applied ``on top
of the normal capital requirements'' to account for any new activities
until sufficient data could be compiled to determine the risk inherent
in such activities. Another commenter recommended three modifications
to the treatment of new activities in the NPR: first, that OFHEO use
historical data from reliable sources and confer with bank regulators
to determine the most appropriate treatments; second, that OFHEO use a
transparent comment process, including review by a technical advisory
board that would allow input on treatments of new activities from all
interested market participants; and third, that the treatments for new
activities should be incorporated timely into the stress test.
c. OFHEO's Response
The Enterprises' recommended approaches, in which they would
implement capital treatments subject to subsequent OFHEO review, are
not practicable within the framework of the final rule because OFHEO
will run the stress test using its own computers and its own
infrastructure. Nevertheless, OFHEO recognizes the importance of making
timely decisions about the capital treatments for new activities.
Before the risk-based capital amount of the affected Enterprise for a
particular quarter can be calculated, those decisions must be made
about all new activities introduced during that quarter. Accordingly,
OFHEO has developed a process to make its own independent and informed
determination of the appropriate capital treatment for new activities
as early as possible, with input from the Enterprises, rather than
relying upon their judgments for the first quarterly capital
classification after a new activity reported in the RBC Report. OFHEO
believes that this process (discussed below) will not impede the
development or introduction of new products or other types of business
innovation.
As discussed above, OFHEO received various recommendations
regarding the appropriate notice and comment procedures for new
activities. OFHEO has fully utilized notice and comment procedures,
discussed at IC., Rulemaking Chronology, in promulgating this
regulation and OFHEO included procedures in NPR2 that will provide
ongoing notice and comment for treatments of new activities. In
addition, the final rule modifies NPR2 to clarify that the Enterprises
are encouraged to provide their recommendations regarding treatments of
their new activities and that the broader public will be notified of
treatments once they are included in a final capital classification.
The public is encouraged to submit their views regarding such
treatments, which will be considered by OFHEO on an ongoing basis.
OFHEO believes that public input in the development of rules is
essential for sound and fair regulation of the Enterprises. At the same
time, to comply with the 1992 Act, OFHEO needed to establish procedures
for new activities that would permit the accurate and timely capital
classifications required by the 1992 Act. Accordingly, the regulation
provides for notice to the affected Enterprise and the public and for
consideration of comments received, while it also ensures the ability
of OFHEO to conduct continuous, timely and complete capital
calculations.
As time passes and a significant volume of new activities has been
addressed through the section 3.11 New Activities process, it may be
appropriate to propose an amendment to the regulation, utilizing the
notice and comment procedures of 5 U.S.C. 553, that would specify
treatments for a group of new activities. Although the public will have
had the opportunity to provide comments on individual activities on an
ongoing basis, this additional process would enable OFHEO to benefit
from supplementary comments that are framed in the context of a broader
body of risks.
In response to the recommendation regarding an external technical
advisory board, OFHEO does not consider it appropriate to require by
rule that such a board review the treatment of all new activities.
OFHEO is satisfied that the wide diversity of technical expertise of
its staff, combined with the normal notice and comment process, will
generally provide adequate analysis and review of new activities.
As to the comment suggesting a capital ``surcharge'' for new
activities on top of the ``regular'' risk-based capital requirement,
OFHEO believes that its approach to new activities is appropriately
flexible to take into account the risks inherent in any new, untested
activity. OFHEO anticipates that it will be able to model effectively
many (if not most) new activities explicitly according to their terms
or with combinations or adaptations of existing treatments. Where the
risk of a new asset type cannot be captured adequately using specified
treatments or combinations or adaptations of treatments, OFHEO may use
an appropriately conservative fixed capital charge instead of or in
addition to an existing modeling treatment. However, in a cash flow
model (in contrast to a leverage ratio approach), a fixed capital
charge may not be the best method to implement a conservative capital
treatment for most instruments. In particular, applying a fixed capital
charge for liabilities or for activities that are designed to reduce
risk is rarely appropriate.
A more appropriate means of increasing the incremental capital
associated with a particular asset in a cash flow model may be to apply
a ``haircut'' to the cash flows from that asset, either directly or by
otherwise specifying certain attributes that are relevant to the cash
flows of these instruments.\50\ A similar approach can be applied to
instruments, such as derivative or insurance contracts that are
designed to reduce risk. To the extent that a liability can not be
modeled according to its terms, the appropriate approach is generally
to
[[Page 47744]]
incorporate certain conservative assumptions about the amount of cash
flow that will be required from the Enterprise.\51\ For these reasons,
OFHEO believes that the flexibility afforded by section 3.11 is
preferable to the imposition of a surcharge for new activities.
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\50\ For example, requiring certain interest-bearing assets that
are on the balance sheet to pay no earnings through the stress
period could be an extremely conservative treatment, because the
liabilities necessary to fund that asset would be paying interest
throughout the stress period.
\51\ If, for example, the amount of interest on a note was
indexed to a volatile indicator that could not be modeled in the
stress test, a conservative treatment might be to require that
instrument to pay interest throughout the stress period at a rate
significantly higher than the average return of the Enterprise on
its assets during that period.
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In sum, the OFHEO has not altered its proposed approach to new
activities, but, based upon the comments, determined that some
clarification of that approach in the final regulation would be useful.
Therefore, the final rule adopts Sec. 1750.12 of the proposed
regulation and section 3.11 of the proposed Regulation Appendix with
some modifications. The revised definition of new activities in section
3.11.1.b of the Regulation Appendix clarifies that the section applies
not only to new transactions and instruments, the most common new
activities, but also other types of new activities. The term ``new
activities'' is, therefore, defined broadly to include any asset,
liability, off-balance-sheet item, accounting entry, or activity for
which a stress test treatment has not previously been applied. This
definition would include any such items that are similar to existing
items, but that have risk characteristics that cannot be taken into
account adequately with existing treatments. The definition further
clarifies that an instrument or activity may be treated as a ``new
activity'' if it increases in volume to such an extent, or if new
information indicates, that an existing treatment does not account
adequately for its risk.
In section 3.11.2.a, which replaces proposed section 3.11(c), the
words ``are expected to'' have been replaced with the word ``shall''
and the phrase ``no later than in connection with submission of the RBC
Report provided for in Sec. 1750.12'' has been replaced with the phrase
``within 5 calendar days after the date on which the transaction closes
or is settled.'' This requirement is also reflected in the regulation
text at Sec. 1750.12(c) in the final regulation. These changes are
designed to address concerns that appropriate capital treatments of new
products be determined as quickly as possible. Timely determinations of
capital classifications and required capital amounts provide an early
warning of a potential strain on an Enterprise's capital. They also
serve the interests of many commenters who felt that delay and
uncertainty about capital treatments of new activities could impede
innovation at the Enterprises.
OFHEO anticipates that, ordinarily, the Enterprises will notify
OFHEO of significant new activities well in advance of entering into
the actual transactions and will provide draft documentation,
anticipated cash flow analysis, and recommended capital treatments as
that information is developed for the Enterprises' internal decision-
making. For new activities that do not involve transactions, such as an
accounting change, OFHEO anticipates that relevant information will be
made available well before actual implementation of the new activity.
This type of coordination will allow OFHEO to develop initial capital
treatments at the same time that an Enterprise is incorporating the new
instruments into its own internal models, reducing uncertainty about
the capital impact of new activities and allowing the new treatments to
be implemented quickly enough to facilitate timely capital calculation
and classification. OFHEO anticipates that the Enterprises will
incorporate into their internal systems and procedures for product
development the process of obtaining the views of OFHEO as to the
appropriate capital treatment of each new activity. However, OFHEO
realizes that it might not always be possible for the Enterprises to
provide notification to OFHEO of a new activity well before submission
of the quarterly RBC Report. As with any federally-regulated financial
institution, if an Enterprise were to market a new instrument or engage
in some new business activity without coordinating with its regulator
to determine, in advance, an appropriate initial capital treatment,
that initial treatment would necessarily be conservative--that is, it
would ensure, in the absence of complete information, that sufficient
capital is set aside to offset any risks that may be associated with
the new instrument or activity.
Section 3.11 as proposed in NPR2 has also been changed to include
three new provisions that expressly state OFHEO's intentions in the
implementation of this section. First, section 3.11.2.a encourages an
Enterprise that is in the process of or has engaged in a new activity
to provide OFHEO with its recommendations regarding the treatment of
that activity when it first provides information regarding the activity
to OFHEO. Any recommendations will be considered by OFHEO in developing
the proposed capital classification. The Enterprise will have the
opportunity to comment on that treatment in connection with its other
comments on the proposed capital classification.
Second, section 3.11.3.d provides that after a treatment has been
incorporated into a final capital classification, OFHEO will provide
notice to the other Enterprise and the broader public of that
treatment. OFHEO will consider any comments it receives from those
parties regarding such treatment during subsequent quarters.
Finally, section 3.11.2.b provides that the stress test will not
give an Enterprise the benefit associated with a new activity where the
impact of that activity on the risk-based capital level is not
commensurate with its economic benefit to the Enterprise. Although it
is not expected that the Enterprises would want to deal in transactions
or instruments that do not have legitimate business purposes, OFHEO
must retain the authority to exclude such instruments from risk-based
capital calculations should they occur.
4. Standardized Reporting
The Enterprises suggested that OFHEO specify a standardized RBC
Report. Such specifications would include sufficiently detailed
instructions to allow the Enterprises to aggregate the data in a format
that can be input directly into the stress test. OFHEO agreed with this
suggestion and has developed such a report. The report will shorten
considerably the time needed to produce the risk-based capital
requirements. It will also provide the Enterprises with more certainty
in performing their own risk-based capital calculations.\52\
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\52\ See II.B., Data.
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5. Capital Classification Process
a. Comments
The Enterprises requested that the regulation describe a practical
and timely process for reporting risk-based capital and determining
capital classifications. A number of specific suggestions were made.
First, they both recommended that they would report stress test results
quarterly along with the data used to run the stress test and OFHEO
would then determine quarterly capital classifications based on the
Enterprises' calculations. Freddie Mac also recommended that OFHEO
classify an Enterprise as adequately capitalized if it meets the
minimum capital requirement and quickly remedies a failure to meet the
risk-based capital requirement before the classification is reported.
Freddie Mac further recommended that OFHEO retain the discretion to
specify when the quarterly
[[Page 47745]]
capital reports are due rather than specifying that they must be filed
within 30 days of the end of the quarter. Finally, Freddie Mac
recommended that the regulation require an Enterprise to amend a
capital report only if a data input revision might result in a capital
reclassification.
b. OFHEO Response
As noted above, OFHEO will run the stress test and determine
capital classifications using its own systems using data reported by
the Enterprises in a standardized format. The Enterprises may duplicate
OFHEO's stress test calculations by running the stress test in the same
manner as OFHEO. If an Enterprise believes there are discrepancies, it
may comment on them during the 30-day response period following OFHEO's
notice of proposed capital classification.
OFHEO did not adopt Freddie Mac's suggestion that the Enterprises
be given an opportunity to remedy capital shortfalls before the capital
classification is reported. Since the risk-based capital requirement is
based on data submitted by the Enterprises as of a particular point in
time, it is appropriate to determine whether an institution meets the
standard as of that date for classification purposes. Although the
classification could be accompanied by a description of any remedial
actions an Enterprise has taken since the reporting date, it would not
be possible to know with certainty that the remedial action brought the
Enterprise into compliance with its risk-based capital standard without
running the stress test again with new starting position data on its
entire book of business.
The final regulation does not change the requirement that the RBC
Report be filed within 30 days of the end of the quarter. OFHEO
believes the RBC Report should be filed as promptly as possible after
the end of quarter so that the capital classification can be determined
promptly, and, in any event, within the same 30 days required for the
minimum capital report. OFHEO recognizes that, initially, Enterprise
preparation of the RBC Report will require more time and effort than is
needed for the minimum capital report. Therefore, during the one year
period following promulgation of the final rule, OFHEO will consider
requests for an extension on a case-by-case basis.
OFHEO has determined that an amended RBC Report should be filed
whenever there are errors or omissions in a report previously filed and
not, as Freddie Mac suggested, only when the change would result in a
different capital classification. In OFHEO's view, prudent monitoring
of risk-based capital requires the reporting of all changes. The rule
makes clear that the Enterprise is obligated to notify OFHEO
immediately upon discovery of such errors or omissions and file an
amended RBC Report within three days thereafter. In addition, the final
rule clarifies that if there is an amended report, the computation of
the risk-based capital level will still be based on the original report
unless the Director, in his/her sole discretion, determines that the
amended report will be used.
The final rule also requires the board of directors of an
Enterprise to designate the officer who is responsible for overseeing
the capital adequacy of the Enterprise as the officer who must certify
the accuracy and completeness of the RBC Report.
NPR2 proposed to delete existing section 1750.5, which sets forth
the capital classification procedure under the minimum capital rule,
and replace it with a new subpart that would govern capital
classification under both the minimum and risk-based capital rules.
Subsequent to the publication of NPR2, OFHEO published a notice of
proposed rulemaking entitled Prompt Supervisory Response and Corrective
Action,\53\ which includes a more comprehensive proposal related to
capital classification than NPR2. Because OFHEO anticipates that the
Prompt Supervisory Response and Corrective Action rule will be adopted
prior to the first classification of the Enterprises under the risk-
based capital rule, existing section 1750.5 is not deleted and proposed
subpart C is not adopted in this final rule.
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\53\ 66 FR 18694 (April 10, 2001).
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6. Interaction With Charter Act Provisions
Freddie Mac requested that OFHEO clarify the interaction of this
risk-based capital regulation with the capital distribution provisions
of Enterprises' respective Charter Acts during the one-year period
following the effective date of the regulation. The Charter Act
provisions are already in effect and have been since enactment of the
1992 Act.
During the one-year period after promulgation of the final rule,
OFHEO will take into consideration the need for the Enterprises to
adjust to the new rule, and will exercise its authority under the
Charter Act provisions in a manner appropriate to the circumstances and
consistent with OFHEO's intent to provide the Enterprises a one-year
transition period to adjust to the risk-based capital requirement.
During such period, there would be no impact on an Enterprise's ability
to make capital distributions absent adequate prior notice to the
Enterprise of its capital position and adequate opportunity to take
reasonable and prudent steps to address any articulated deficiency.
7. Implementation
OFHEO has taken appropriate proactive measures to ensure a smooth
implementation of the risk-based capital (RBC) rule and the computer
code that implements the rule. These measures, which include
independent verification and testing of the code, minimize the
likelihood of unforeseen technical or operational issues. However,
should any such issues arise, OFHEO has ample and flexible authority,
which it will utilize to resolve them quickly.
a. Computer Code Enhancements
After publication of the RBC rule, OFHEO will make available to
requesting parties the computer code that implements the technical
specifications of the rule and a dataset representative of the
Enterprises' businesses. OFHEO encourages feedback on the operation of
the code by parties who utilize it, including suggestions for more
efficient ways to code the technical specifications of the rule.
The computer code that implements the RBC rule will necessarily
evolve over time as the businesses of the Enterprises evolve and as
OFHEO builds efficiencies into the code to enhance its operation and
utility. Also, as the Enterprises seek to adapt their systems to run
the stress test internally, they may suggest alternative methods of
coding the technical specifications of the rule that would enable them
to compile their data submissions more quickly or produce results more
efficiently. OFHEO will consider adopting a suggested change in the
code provided it accurately reflects the computational instructions of
the rule and can be applied accurately and fairly to both Enterprises.
OFHEO will develop a process for the receipt, review, and disposition
of suggested changes to the code.
In addition, OFHEO has the authority to make any changes it deems
necessary to the code at any time, without notice and comment, as long
as those changes are not inconsistent with the technical specification
of the RBC rule. This authority allows OFHEO to address any technical
or other problems that might arise in the operation of the code on a
timely basis. Any changes to the code will be made available to the
public.
[[Page 47746]]
b. RBC Rule Revisions
OFHEO will consider over time the need for formal amendments to the
RBC rule after its effective date. If at any time after the effective
date a need arises to amend the rule on an urgent basis, OFHEO has
ample authority under the 1992 Act \54\ to make such changes on a
timely basis consistent with the APA. The Senate Report accompanying
the 1992 Act makes it clear that Congress recognized that the stress
test must necessarily evolve as the Enterprises' businesses evolve and
contemplated that a variety of procedural options for quick action
would be necessary to keep current the risk-based capital regulation.
In regard to the risk-based capital regulation, the Report states that
``[t]he regulations must be sufficiently detailed to allow others to
comment meaningfully on them and approximate closely their effects.''
It goes on to emphasize that ``[o]rders or guidelines may be used for
some of the finer details to permit flexibility to make small changes
on a rapid basis when necessary.'' \55\
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\54\ 12 U.S.C. 4513, 4526, 4611.
\55\ S. Rep. No. 102-262 (1992), p. 23.
---------------------------------------------------------------------------
The APA provides a variety of procedural options that would be
available to remedy technical problems in the RBC rule, whether they
are minor or significant. First, the Director may act quickly, without
notice and comment, to make technical corrections, clarifications, or
interpretations of the rule. This authority would permit most technical
and operational problems to be remedied expeditiously. The Director
would publish the correction, clarification, or interpretation of the
rule in the Federal Register and make revisions to the code available.
Second, should a more substantive change to the technical
specifications be required, the Director may separately issue a direct
final rule or a final rule on an interim basis with request for
comment, either of which would take effect immediately. Third, the
Director, in a separate rulemaking with a relatively short comment
period, may propose amendments to the risk-based capital regulation and
move quickly to a final rule amending the risk-based capital
regulation. These and other administrative tools are available to
address any technical or operational problems that may arise in the
implementation of the rule.
C. Implications
OFHEO received extensive comments about the implications of the
proposed risk-based capital rule from the Enterprises, financial
service organizations, trade associations, and affordable housing
advocacy groups. The commenters focused on three primary issues: (1)
Whether the risk-based capital rule properly aligns required capital to
economic risk, (2) whether the rule would increase the cost of home
ownership generally; and (3) whether the rule would result in the
Enterprises reducing their support for affordable housing. There was a
diversity of opinion on these issues. Commenters also provided many
specific recommendations with respect to the implications of the risk-
based capital rule. OFHEO has responded to these recommendations under
the specific topics to which they relate.
1. Aligning Capital to Economic Risk
The commenters generally agreed that a stress test is an
appropriate method to align capital to risk. Nevertheless, some
commenters, including the Enterprises, investment firms, and some trade
associations, stated that OFHEO needs to improve the alignment of
capital to economic risk and offered specific suggestions to accomplish
this, which are discussed under the specific topics to which they
relate. These commenters claimed that failure to align capital to
economic risk may reduce the availability of certain products, create
disincentives to risk sharing and risk reduction, and result in price
distortions.
OFHEO continues to believe that the significant stresses that the
regulation applies to the Enterprises' books of business are
appropriate for determining the risk-based capital requirement and to
align required capital closely to the economic risk. Nevertheless, many
of the modifications to the regulation made by OFHEO align capital more
closely to the economic risk, based in part on specific suggestions
offered during the rulemaking process. These modifications are also
discussed under the specific topics to which they relate. As a result
of these changes, OFHEO believes that the final risk-based capital rule
provides an even better mechanism for closely aligning regulatory
capital to economic risk than the proposed rule.
OFHEO is charged with ensuring the continued viability of the
regulated entities so that they can continue to carry out their
important public purposes, including promoting affordable housing and a
stable and liquid secondary mortgage market. As a financial regulator,
OFHEO may have a different perspective on the types of risks that must
be capitalized and the appropriate corresponding capital levels than
the financial institutions it regulates. Prudent risk managers
generally respond to increased risk by either increasing their capital
in line with the increase in risk or by taking steps to reduce or hedge
risk. Publicly traded companies, such as the Enterprises, will always
be under pressure to obtain a competitive return on equity for their
shareholders and to maintain a significant level of capital
distributions. OFHEO's risk-based capital regulation provides a strong
incentive for the Enterprises to resist excessive shareholder pressure
for short-term returns and essentially requires the Enterprises to
exercise the kind of prudent risk management that will ensure that they
have sufficient capital to protect them in times of economic stress and
volatility.
2. Effect on Home Ownership Generally
a. Comments
Commenters voiced significant disagreement about whether the risk-
based capital rule would increase mortgage rates and the cost of home
ownership generally. The Enterprises, Wall Street investment firms, and
some trade groups expressed concern that the proposed regulation would
require an Enterprise to hold what they termed an ``unreasonable''
amount of capital. These commenters asserted that requiring an
``unreasonable'' amount of additional capital would increase mortgage
interest rates and thus decrease the affordability of a mortgage and
the availability of funding for home purchases.
Other financial services organizations, including GE Capital, AIG,
and CMC argued that higher capital requirements do not necessarily
translate into higher mortgage interest rates. They noted that the
Enterprises have several options other than passing along the cost of
higher capital to lenders and ultimately home buyers. For instance,
these commenters stated that the Enterprises could issue additional
equity, take on less risk, or implement various risk mitigation
activities. These commenters further noted that critics of the risk-
based capital proposal focused only on the negatives, while ignoring
the benefits of an effective risk-based capital standard, particularly
the significant benefit of decreasing the risk of failure of the
Enterprises. One commenter stated that OFHEO should err on the side of
requiring more capital rather than less, given the Enterprises' size
and importance to the U.S. economy.
b. OFHEO's Response
After a review and analysis of the comments, OFHEO concluded that
the risk-based capital regulation, as
[[Page 47747]]
modified, properly implements Congress' desire for the Enterprises to
hold an appropriate level of capital to minimize the risk of failure of
the Enterprises, increasing the likelihood that the Enterprises can
continue to carry out their important public purposes. The significant
credit and interest rate stresses mandated by the 1992 Act are designed
to produce a capital requirement that encourages the Enterprises to
manage risk appropriately and that results in a capital requirement
that adequately reflects risk.
OFHEO does not agree that the rule would necessarily or even likely
result in higher mortgage rates that would ultimately be passed along
to consumers. First, OFHEO believes that the Enterprises will be able
to meet the requirements of the regulation at relatively little or no
cost, as discussed in NPR2.\56\ Moreover, prices are not tightly tied
to costs in any event. Second, because the Enterprises are subject to a
stringent capital regulation, the financial markets may perceive that
the Enterprises are less risky. Such a market assessment would likely
be reflected in the pricing of the Enterprises' debt and equity,
especially subordinated debt, which is particularly market sensitive.
Third, even if the risk-based capital regulation were to have some
minor effect on one Enterprise's cost of lending and that Enterprise
attempted alone to pass this cost along through higher guarantee fees,
that Enterprise would risk losing market share.
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\56\ 64 FR 18114, April 13, 1999.
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As noted by several commenters, an Enterprise has numerous cost-
effective methods to offset any additional risk-based capital
requirements and may adjust to the standard in ways that do not
necessarily result in increased mortgage rates. OFHEO agrees with this
observation and notes that an Enterprise has several options to
accomplish this task. For instance, financial markets provide a wide
array of sophisticated ways to manage interest rate risk, including
callable long-term debt, caps and floors, swaps and swaptions, and
interest rate derivative contracts. In addition, an Enterprise could
reduce credit and interest rate risk by reducing the rate of growth of
its asset portfolio, increasing the credit protection on riskier assets
that it guarantees or holds in portfolio, or reducing the rate of
growth of its mortgage guarantee business. An Enterprise may also
respond to increased capital requirements by increasing capital by
reducing share repurchases, adjusting dividends, or issuing new equity
shares.
OFHEO therefore concludes that an Enterprise has broad latitude to
select the method or methods to manage its risks and comply with the
risk-based capital requirement without increasing mortgage rates. These
various strategies will have different direct costs, but may well
result in fewer credit and interest rate losses over time.
3. Effect on Affordable Housing
a. Comments
A number of commenters voiced significant disagreement about
whether the risk-based capital rule would impair the Enterprises'
efforts to promote the availability of mortgage funds to support
affordable housing for low- and moderate-income Americans. The
Enterprises, affordable housing advocacy groups, and some trade
associations and financial firms expressed concern that the rule may
cause the Enterprises to decrease the availability of funds used to
purchase affordable housing. These commenters believed that the rule
could impair the Enterprises' ability to serve low-income borrowers and
hinder the financing of multifamily and rental properties. One
commenter stated that the Enterprises should be awarded capital bonuses
for engaging in affordable housing activities.
In contrast, other financial service organizations stated that
there is no ``automatic'' conflict between having rigorous capital
standards for the Enterprises and increasing the supply of funds for
affordable housing. These commenters noted that HUD, not OFHEO, should
address affordable housing issues through its affordable housing
regulations.
b. OFHEO's Response
OFHEO continues to believe that the risk-based capital standard
will not have a noticeable adverse affect on the Enterprises' ability
to purchase affordable housing loans, particularly with respect to
single family loans. OFHEO notes that the Enterprises obtain similar
profitability from their affordable housing loans as their general loan
portfolio. As OFHEO noted in NPR2,\57\ the capital cost of single
family loans meeting HUD's affordable housing goals is not materially
different from the cost of other loans for equivalent loan-to-value
(LTV) ratios. Although the stress test distinguishes among loans based
on LTV ratios, it makes no specific distinctions with respect to loans
to different income groups. Moreover, OFHEO has modified the single
family model to calibrate defaults to the benchmark loss experience by
LTV category, which should alleviate some of the commenters' concerns
about the treatment of high LTV loans. See III.I.1., Single Family
Mortgage Defaults and Prepayments. OFHEO further notes that the
Enterprises' affordable housing programs are currently well run, and
the Enterprises effectively mitigate increased risks associated with
high LTV loans with credit enhancements. In addition, the final rule
modifies the treatment of low-income housing tax credits, which some
commenters considered to be punitive. See III.N., Accounting, Taxes,
and Operating Expenses.
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\57\ 64 FR 18116, April 13, 1999.
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OFHEO disagrees with the comment that OFHEO should award capital
bonuses to an Enterprise for engaging in affordable housing activities.
OFHEO agrees with those commenters who stated that HUD's affordable
housing regulations are the appropriate method for ensuring that
sufficient attention is given to affordable housing. The purpose of the
risk-based capital regulation is to ensure that the Enterprises'
capital is properly aligned with risk. Even if the risk-based capital
standard required additional capital related to a portion of the
Enterprises' affordable housing activities, such a requirement would be
consistent with ensuring that the Enterprises hold sufficient capital
for the risks they take. Failure to align capital with the credit risk
of particular loan programs could result in curtailment or cessation of
those programs. Freddie Mac's early experience with multifamily loans
is a case in point. Losses on that program caused Freddie Mac to cease
multifamily lending altogether in the early 1990s.
D. Benchmark Loss Experience
In NPR1, OFHEO proposed the methodology to identify the contiguous
areas containing five percent or more of the U.S. population that
experience the highest rate of default and severity of mortgage losses
for a time period of two or more years as required by the 1992 Act.\58\
Losses experienced by loans in the identified time and place are
referred to as the ``benchmark loss experience.'' The credit stress of
the stress test must be reasonably related to the benchmark loss
experience.
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\58\ 12 U.S.C. 4611(a)(1).
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The proposed methodology involves four steps. The first step is to
identify the benchmark loss experience using historical loan-level data
submitted by each Enterprise. The analysis is based on currently
available data of conventional, 30-year fixed-rate loans
[[Page 47748]]
secured by first liens on single-unit, owner-occupied, detached
properties. The data include only loans that were purchased by an
Enterprise within 12 months after loan origination and loans for which
the Enterprise has no recourse to the lender. The second step is to
organize the data from each Enterprise to create two consistent data
sets. During this process, OFHEO separately analyzes default and
severity data from each Enterprise. The third step is to calculate for
each Enterprise the cumulative 10-year default rates and severity rates
for each combination of States and origination years (State/year
combination) by grouping all of the Enterprise's loans originated in
that combination of States and years. In this step, hundreds of State/
year combinations are calculated and analyzed. The fourth step is to
calculate the ``loss rate'' by multiplying the average default rate for
that State/year combination by the average severity rate. The State/
year combination fulfilling the population and time requirements with
the highest loss rate constitutes the benchmark loss experience. Using
this methodology, OFHEO identified loans originated in 1983-1984 in the
four State region of Arkansas, Louisiana, Mississippi, and Oklahoma
(ALMO) as the current benchmark loss experience (``ALMO benchmark loss
experience'').
In NPR2, OFHEO described how the benchmark loss experience would be
used in the stress test and, building on the methodology proposed in
NPR1, used the benchmark cohort of loans \59\ to conduct simulations to
demonstrate the sensitivity and implications of the proposed rule. As
explained in NPR2, the equations used in the mortgage performance
models are estimated based upon OFHEO's historical database of mortgage
information to predict the most likely default and severity rates for
any given group of mortgages under any given pattern of interest rates
and house prices.\60\ NPR2 also proposed methods of reasonably relating
the credit stress of the stress test to the benchmark loss experience.
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\59\ Those conventional 30-year fixed-rate loans in the State/
year combination (i.e. loans originated in ALMO in 1983-1984) with
the highest loss rate.
\60\ See 64 FR 18118, April 13, 1999, for a more detailed
description.
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1. Methodology
Most commenters, including the Enterprises, mortgage insurers, and
trade groups, generally stated that the proposed methodology was
workable, but suggested changes. A number of commenters, who criticized
the benchmark loss experience methodology based on NPR1, were
significantly less concerned when they evaluated the issue in the
context of NPR2. Freddie Mac concurred generally with OFHEO's
methodology to identify the benchmark loss experience and specifically
with the selection of the ALMO benchmark loss experience. Nevertheless,
as discussed below, Freddie Mac stated that the historical data used to
identify the benchmark loss experience should be adjusted or else the
benchmark loss experience default and loss severity rates' loss rates
would be overstated. Fannie Mae stated that while the methodology for
identifying the benchmark loss experience has certain difficulties,
such difficulties could be addressed by adjusting the default and
severity models. GE Capital stated that because the proposed
methodology is reasonable, any changes should wait until the next
generation of the model.
Commenters had divergent views on whether the credit conditions
identified by the methodology were sufficiently stressful. Some
commenters claimed that the proposed methodology does not produce a
benchmark loss experience that is stressful enough. These commenters
asserted that the proposed methodology identified only a two-year
origination period rather than a ten-year period for default and
severity rates and that by averaging certain factors (e.g., time and
Enterprises' default rates), the methodology resulted in an average
rather than a worst case scenario. In contrast, other commenters,
including the Enterprises, stated that the benchmark loss experience
was more severe than any national experience and more severe than could
be expected to occur in a diversified national economy.
The final regulation makes no changes in the proposed methodology
for identifying the benchmark loss experience. In evaluating the
commenters' suggestions for modifications, OFHEO's first priority was
to implement the 1992 Act appropriately. Accordingly, OFHEO determined
that it was appropriate under the statute to select the loans
originated during a two-year period that had the highest ten-year
cumulative default and severity rate (rather than selecting the two-
year period that experienced the highest losses on all loans) and to
average between the Enterprises. Further, because the purpose is to
identify a regional benchmark loss experience and apply it to the
nation as a whole, OFHEO did not consider the comments about geographic
diversification to be relevant.
OFHEO also sought to balance the benefit of the recommended
modifications with the associated costs. With respect to costs,
adopting the recommended modifications would divert time and resources
from modifications to the stress test in response to comments, delaying
the issuance and implementation of the regulation. Based on an analysis
of the proposed methodology in light of the related comments, OFHEO has
concluded that implementing the commenters' recommendations for
revising the methodology would at best provide only modest improvements
in identifying a benchmark loss experience, and in some cases would
provide little or no benefit. Consequently, OFHEO has decided not to
modify the methodology at this time. The proposed methodology provides
a reasonable method for identifying the region in which the
Enterprises' mortgage loans experienced their worst credit losses.
2. Data Issues
The dataset used to identify the benchmark had certain limitations.
Fannie Mae is unable to provide complete historical data for purposes
of identifying the benchmark loss experience. Specifically, Fannie Mae
has no loss severity data for retained loans originated before 1987 or
for loans securitized under its swap program before 1991. In addition,
a number of loans were misclassified by Fannie Mae. In NPR1, OFHEO
concluded that, for the purpose of the benchmark analysis, it would be
better to use the available data, than to speculate about the missing
data or otherwise make adjustments to account for the missing or
misclassified data.
Both Enterprises expressed concern that without making adjustments
to account for the missing data, the benchmark loss experience
calculation would overstate the actual default and loss severity rates.
They were particularly concerned that these rates would be overstated
for the ALMO benchmark loss experience in those years. Accordingly,
they recommended that OFHEO introduce weighting and other techniques to
adjust for the missing data. With respect to the missing swap program
data, Freddie Mac recommended that OFHEO compare mortgages purchased
under Fannie Mae's swap program with Freddie Mac's own program, and
adjust the default rates accordingly. With respect to missing pre-1987
loss severity data, Freddie Mac recommended that OFHEO adjust the
available loss severity data by weighting techniques to
[[Page 47749]]
eliminate what it viewed as bias caused by assuming all loans were 30
year fixed-rate loans. The effect of this adjustment would lower loss
severity rates in the benchmark loss experience.
After analyzing the comments, OFHEO has confirmed its original
determination that it would be inappropriate to modify or otherwise
``adjust'' for the missing Fannie Mae historical data. It does not
appear that Fannie Mae will ever be able to provide this data, and any
attempt to adjust existing data based on assumptions about non-existing
data would be speculative at best. Accordingly, OFHEO declines to
introduce any additional weighting techniques or other assumptions to
its initial decision to use the historical data as they exist. OFHEO
believes that using the data as submitted by the Enterprises is
appropriate, particularly given that the Enterprises' recommendations
were based on speculative premises about how historical data would
perform rather than empirical or other quantitative evidence.
3. Benchmark Region and Time Period
In NPR1 and NPR2, OFHEO stated that it would periodically monitor
available data and reevaluate the benchmark loss experience using the
methodology set forth in the Regulation Appendix. OFHEO noted that,
using this methodology, it may identify a new benchmark loss experience
in the future that has a higher loss rate than the one identified at
the time of the regulation's issuance. It further noted that if such a
benchmark is identified, OFHEO may incorporate the resulting new
benchmark loss experience in the stress test.
Freddie Mac requested that the regulation specify not only the
methodology to identify a benchmark loss experience, but also a
specific benchmark loss experience, such as the ALMO benchmark loss
experience for loans originated in 1983-1984. OFHEO has determined that
it is more appropriate to include only the methodology in the
regulation. The 1992 Act does not require that OFHEO specify a
particular benchmark region and time period in the regulation.
Moreover, given Congress' desire for the benchmark loss experience to
represent a stressful credit environment, it would be inappropriate to
reduce OFHEO's flexibility to identify a different benchmark loss
experience if new data indicate that a change is appropriate.
4. Compactness
Freddie Mac suggested adding an additional criterion to the
statutory criteria for identifying the benchmark loss experience.
Specifically, Freddie Mac recommended that the regulation include what
it termed a ``compactness'' requirement so that, in addition to the
statutory requirement that the benchmark region comprise ``contiguous''
areas, the benchmark region would have to be a region in which a person
could travel from any one State to any other State in the region,
without traveling through more than one other State within the region.
OFHEO has determined that modifying the definition of the benchmark
loss experience to include an additional compactness requirement is
inappropriate and would be unworkable. As discussed in NPR1, OFHEO
rejected options that would not provide for a reasonably compact
benchmark region. For that reason, the proposed regulation specified
States as the smallest geographic unit rather than using smaller
geographic units such as zip codes and rejected a definition of
``contiguous'' that would include meeting at a point. It is possible
that using smaller units could result in the equivalent of a
gerrymandered benchmark loss experience in which it would contain only
units with relatively more severe loss experience while excluding
regions in the same State with a more benign loss experience. Freddie
Mac's recommendation would impose an additional requirement that goes
beyond what Congress specified and could preclude identification of an
appropriately stressful credit environment. Moreover, the modification
recommended by Freddie Mac might be difficult to determine and even
unworkable, since there could still be numerous non-compact regions
that would comply with Freddie Mac's recommended definition of
compactness.
5. Population Requirement
Fannie Mae expressed concern that the ALMO benchmark loss
experience may contravene the requirement that the benchmark loss
experience contain at least five percent of the United States
population, since it believed that the ALMO benchmark loss experience
includes States that contribute significant parts of the population but
may have few mortgage loans. That Enterprise was also concerned that
the ALMO benchmark loss experience may not meet the five percent
requirement over the entire stress period.
OFHEO has determined that neither concern is valid. First, the 1992
Act requires that the benchmark loss experience include ``contiguous
areas of the United States'' containing at least five percent of the
U.S. population. The statutory provision does not address the
distribution of loans within that area or specify the designation of a
``State'' as a factor. Accordingly, it is the population of the
identified area, not of a State or States within it, that is relevant
in determining the benchmark loss experience. Second, the 1992 Act only
addresses the population and not the number of mortgage loans. Congress
could have specified loan volume as a criterion, but did not, and OFHEO
declines to read such a specification into the statute. Third, the 1992
Act does not require that the population requirement be met during the
entire stress period for the purpose of determining the benchmark loss
experience. The statute only requires the stress conditions to persist
for ``two or more years.'' The ALMO benchmark loss experience complies
with the statute because it had over five percent of the United States'
population in the two year period of 1983 and 1984. OFHEO further notes
that a region experiencing significant credit stresses may very well
experience a decrease in population. Including the additional
limitations suggested by Fannie Mae would reduce the severity of the
benchmark loss experience and the stress test as a whole, a result that
was not intended by Congress. Based on these considerations, OFHEO
concludes that each of Fannie Mae's arguments is without merit.
6. Improvements in the Underwriting
GE Capital, in its reply comments, expressed concern that OFHEO
would be persuaded by the Enterprises' arguments that the benchmark
loss experience should be adjusted to reflect improvements in their
underwriting practices, subsequent to the benchmark period. GE noted
that although the Enterprises have improved their underwriting
techniques since 1986, these improvements may not serve to reduce the
frequency of default rates, given regional recessions such as in
California and New England that occurred after 1986.
OFHEO believes that it would be inconsistent with the 1992 Act and
inappropriate to adjust the benchmark loss experience based on the view
that the Enterprises have improved their underwriting. First, improved
underwriting is not relevant to identifying the benchmark loss
experience, i.e., the worst time and place for credit stress. Rather,
Congress intended the benchmark loss experience to define a severe
level of credit stress that the Enterprises should be able to survive
during a ten year period. To
[[Page 47750]]
``adjust'' for improved underwriting would be inconsistent with the
statute, since it suggests that the Enterprises could never experience
such a level of credit stress again. In addition, periodic
modifications based on changes in underwriting would be difficult to
implement.
E. Enterprise Data
In NPR2, OFHEO explained that the stress test would utilize data
characterizing an Enterprise's assets, liabilities, stockholders
equity, and off-balance sheet items at a point in time (``starting
position data''). Under the proposal, OFHEO anticipated that each
Enterprise would submit all data for mortgages, securities, and
derivative contracts at the instrument level. The proposed stress test
aggregated individual loans into groups with common risk and cash flow
characteristics, known as ``loan groups.''\61\ Data for these loans
groups, instead of individual loans, were used as inputs by the
mortgage performance and cash flow components of the stress test. In
addition to the loan groups for existing loans, the stress test created
loan group data for mortgages expected to be added to the Enterprises'
books of business as a result of commitments outstanding as of the
reporting date, using a process that is discussed in the
``Commitments'' section of this preamble III. F., Commitments. With
respect to nonmortgage financial instruments (investments, debt, and
derivative contracts), NPR2 proposed to project their cash flows at the
individual instrument level rather than at an aggregated level, because
they are fewer and more diverse.
---------------------------------------------------------------------------
\61\ For example, a loan group might include all 30-year fixed-
rate mortgages for single family homes in the same geographic
region, originated in the same year, with similar interest rates and
LTVs, and held in an Enterprise's portfolio. Such a process would
allow over 24 million loans to be aggregated into a smaller number
of loan groups that capture the important risk characteristics. Even
with aggregation, there would be thousands of loan groups.
---------------------------------------------------------------------------
1. Comments
Only Freddie Mac and Fannie Mae commented on OFHEO's proposed
treatment of Enterprise data for the stress test. Both Enterprises
emphasized the complexity of the proposed data submission process.
Freddie Mac stated that in its submission for the second quarter of
1997, it provided more than 600 million data elements to OFHEO, which
OFHEO then ``translated'' into data sets. It stated that this process
results in ``a substantial number of translation errors'' which could
impair the accuracy and reliability of the stress test. Similarly,
Fannie Mae attributed most of the difficulty in operationalizing the
stress test to the use and handling of instrument-level data, since the
regulation requires the exchange, management and application of data on
hundreds of thousands of different instruments and contracts.
Because of these problems, both Enterprises recommended that they,
rather than OFHEO, be responsible for compiling and, where appropriate,
aggregating the data into a standardized report, which would then be
submitted to OFHEO. Freddie Mac stated that OFHEO should eliminate the
need to perform data file translations by requiring the Enterprises to
report their data files in a standardized format that OFHEO specifies
in a ``call-report-like'' approach. Similarly, Fannie Mae recommended
that each Enterprise submit a RBC Report with standardized
elements.\62\ Both Enterprises stated that such an approach is similar
to the one taken by other Federal financial regulators with their
reporting and capital requirements.
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\62\ These recommendations were accompanied by recommendations
that the Enterprises be allowed to use models they would develop to
OFHEO specifications to compute their risk-based capital requirement
and report it to OFHEO along with the RBC Report. This
recommendation is discussed in III. B., Operational Workability of
the Regulation.
---------------------------------------------------------------------------
2. OFHEO's Response
Consistent with the comments, OFHEO has decided to have the
Enterprises compile, and, where appropriate, aggregate their data and
submit it to OFHEO in a standardized format specified by OFHEO. To
implement this approach, OFHEO has specified a RBC Report with
instructions for aggregating and reporting data in a standardized
format. OFHEO agrees with the commenters that the data submission
process must result in the submission of complete and accurate inputs
to allow for the reliable and timely generation of a risk-based capital
number. OFHEO believes that the approach in the final rule will fulfill
this goal, because it serves to increase the efficiency and
transparency of the process and the timeliness of the capital
classification. OFHEO further believes that the data submission process
will continue to be reliable, because each Enterprise will be required
to certify that its submission is complete and accurate. In addition,
the compilation of such data by the Enterprises will be subject to
examination by OFHEO. This approach will permit capital classifications
to be more timely because the standardized data can be input directly
into the stress test without the need for data translation by OFHEO.
The stress test makes provision for items reported by the
Enterprises that do not fall into the categories specified in the RBC
Report or items for which the data is incomplete. If the item is a new
activity, it will be treated as specified in section 3.11, Treatment of
New Enterprise Activities, of the Regulation Appendix. Otherwise, where
there is no appropriate specified treatment in the Regulation Appendix,
or where data required to model the item are missing and there is no
computational equivalent for such data and no available proxy
acceptable to OFHEO, the item will be given one of the conservative
treatments specified in section 3.9, Alternative Modeling Treatments,
of the Regulation Appendix, depending on whether the item is an asset,
a liability, or an off-balance sheet item. The treatments vary in the
up-rate and down-rate scenarios and prescribe values for missing terms
needed to determine cash flows. It is necessary to make provision for
such items in order to permit the stress test to operate with
incomplete data and to take into account highly unusual items that
cannot be accommodated by specific stress test treatments. OFHEO
expects that there will be few of these items in any given quarter.
F. Commitments
1. Background
The 1992 Act specifies that during the stress period the
Enterprises will purchase no additional mortgages nor issue any MBS,
except that--
[a]ny contractual commitments of the enterprise to purchase
mortgages or issue securities will be fulfilled. The characteristics
of resulting mortgage purchases, securities issued, and other
financing will be consistent with the contractual terms of such
commitments, recent experience, and the economic characteristics of
the stress period.\63\
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\63\ 12 U.S.C. 4611(a)(3)(A). The 1992 Act does provide for
later amendment of the rule to address new business during the
stress period, but not until after the risk-based capital regulation
is final. The 1992 Act requires that, within one year after this
regulation is issued, the Director of the Congressional Budget
Office and the Comptroller General of the United States shall each
submit to the Congress a study of the advisability and appropriate
form of any new business assumptions to be incorporated in the
stress test. 12 U.S.C. 4611(a)(3)(C). 12 U.S.C. 4611(a)(3)(B)
authorizes the Director to consider these studies and make certain
new business assumptions. However, that subparagraph does not become
effective until four years after the risk-based capital regulation
has been issued.
The term ``contractual commitments'' generally refers to binding
agreements that the Enterprises enter into with
[[Page 47751]]
seller/servicers to purchase mortgages or to swap mortgages for MBS.
The term also refers to agreements to sell such securities to
investors.
In NPR2, OFHEO proposed to model commitments outstanding on the
beginning date of the stress test by adding new loans to the books of
business of the Enterprises during the first year of the stress test,
using specified decision rules that govern the volume and
characteristics of these new loans. To avoid the complexity of modeling
the mix of securitized mortgages versus those purchased for portfolio
(which is largely determined by seller/servicers, based on a number of
market factors) NPR2 specified that all loans delivered under
commitments would be securitized. Second, NPR2 specified that, in the
down-rate scenario, 100 percent of all loans that the Enterprises are
obligated to accept would be delivered and, in the up-rate scenario, 75
percent of those loans would be delivered. Third, the proposal
specified that, in the up-rate scenario, loans would be delivered over
the first six months of the stress test and, in the down-rate scenario,
over the first three months, at the rates specified in Table 3.
Table 3.--Mortgage Deliveries by Month of the Stress Test as a
Percentage of Total Commitments
------------------------------------------------------------------------
Up-Rate Down-Rate
Months Scenario Scenario
------------------------------------------------------------------------
1 18.75% 62.50%
------------------------------------------------------------------------
2 18.75% 25.00%
------------------------------------------------------------------------
3 12.5% 12.50%
------------------------------------------------------------------------
4 12.5% 0.00%
------------------------------------------------------------------------
5 6.25% 0.00%
------------------------------------------------------------------------
6 6.25% 0.00%
------------------------------------------------------------------------
Total 75% 100%
------------------------------------------------------------------------
Finally, OFHEO proposed that the mix of characteristics (type,
term, LTV ratio, coupon, geographic location, and credit enhancements)
of commitment loans would be based upon the characteristics in loans
that were delivered for securitization within the immediately preceding
six-month period.
2. Comments and Responses
a. General Comments
Only the two Enterprises commented upon the proposed treatment of
commitments. Both Enterprises agreed with OFHEO's decision that all
loans delivered under commitments would be securitized. On the other
hand, both Enterprises expressed concern that the capital impact of
commitments was too great and that the stress test may overstate the
risks posed by outstanding commitments. They cautioned that such an
overstatement could reduce the use of certain types of commitments.
Freddie Mac stated that OFHEO's approach was probably more complex
than is warranted, but, nevertheless, would be operationally workable.
However, Freddie Mac also stated that if its recommended changes in the
modeling approach to commitments and adjustments to the benchmark loss
experience are not made, the Enterprises will have strong economic
incentives to reduce the use of longer term commitments and further
that ``it is doubtful that commitments could support [NPR2] capital
levels.'' Fannie Mae made similar comments, suggesting that ``the
proposed regulation's failure to recognize behavioral differences among
commitment types may unnecessarily restrict the widespread use of
optional commitments.''
In response, OFHEO notes that its decisions about how to model
commitments are not intended to promote or discourage the use of one
type of commitment over another, or to encourage the use of commitments
in general. To the extent that long-term commitments may have a greater
capital impact than short-term commitments, that is due to the relative
level of risk of each type of commitment. Further, if empirical
analysis regarding commitments indicates that the stress test should be
modified, OFHEO will consider doing so. However, in the absence of
historical data from which to construct a statistical model of
commitments, the final regulation includes a few straightforward and
conservative decision rules, which reflect the conditions of the stress
period and the operation of commitment agreements. These rules make the
commitments model easily replicable and the impact of commitments on
capital predictable.
b. Remittance Cycle
Freddie Mac pointed out that NPR2 proposes to set the remittance
cycle for commitment loans to the shortest period used at each
Enterprise, even though some loans delivered and securitized just prior
to the start of the stress period might have different remittance
cycles. The final rule responds to this comment by modeling the float
period (the time between receipt of funds by the Enterprise and
remittance to security holders), which is the relevant portion of the
remittance cycle for securitized loans.\64\ The float period is set
using the average float days weighted by UPB for each commitment loan
group category in the same proportions experienced by each Enterprise
in securitized single family loans that were originated and delivered
within six months prior to the start of the stress test.
---------------------------------------------------------------------------
\64\ See sections 3.2.2.1, Loan Data and 3.6.3.7.2, Stress Test
Whole Loan Cash Flow Inputs, of the Regulation Appendix which
require float days as an input.
---------------------------------------------------------------------------
c. Credit Enhancements
Freddie Mac pointed out that, although commitment loan groups used
in the model carried credit enhancements based upon each Enterprise's
history for the prior six months, the NPR did not specifically
reference credit enhancements among the characteristics of the loan
groups. The final rule clarifies that mortgage insurance credit
enhancements will be assigned to the commitment loans in the same
proportions experienced by each Enterprise in securitized single family
loans that were originated and delivered within six months prior to the
start of the stress test. OFHEO notes that credit enhancements other
than mortgage insurance are not applied to commitment loan groups in
the final rule. Given the change to contract-level detail in the
modeling of credit enhancements in the final rule, assignment of other
types of credit enhancements would have required OFHEO to include
speculative assumptions about the terms of future credit enhancement
contracts. Including these other enhancements would also have added
excessive complexity to the model, given the relatively small number of
loans that would be affected.
d. Alternative Delivery Assumptions
(i) Comments
Fannie Mae recommended alternative modeling assumptions that, it
asserted, better distinguished between the different types of
commitments than those treatments proposed by OFHEO.\65\ Fannie Mae
suggested that OFHEO erred by treating all outstanding commitments as
the same type of contractual arrangement. Specifically, Fannie Mae
stated that the specified percentages of loans delivered under
commitments (fill rates) ignore the large number of optional
commitments and suggested that fill rates of 50 percent in the up-rate
and 75 percent in the down-rate would
[[Page 47752]]
be most appropriate. Fannie Mae also asserted that the three- and six-
month delivery windows were unrealistically short and that deliveries
in both scenarios were too front-loaded, suggesting instead periods of
six and twelve months with deliveries spaced evenly across those
periods. Fannie Mae further suggested that OFHEO refine the definition
of ``commitment'' to reflect different levels of commitment in
different agreements, although it did not explain precisely how this
refinement should be reflected in the stress test.
---------------------------------------------------------------------------
\65\ Fannie Mae's NPR2 comment letter also included an ``Issue
Brief'' authored by Ernst & Young LLP, which provided further detail
supporting Fannie Mae's recommendations.
---------------------------------------------------------------------------
(ii) OFHEO Response
OFHEO has studied the alternatives recommended by Fannie Mae and
has concluded that they are no more precise or reasonable than those in
the proposed regulation. First, contrary to Fannie Mae's assertion,
OFHEO did not assume that all commitments were of the same type.
Specifying less than 100 percent deliveries in the up-rate scenario is
a recognition that some commitments are optional and that sellers under
those commitments are not required to deliver all the loans specified
in the agreement. Second, OFHEO determined that the front-loaded
delivery schedule is appropriate because deliveries under individual
commitment contracts tend to be concentrated in the early months of the
contract. This decision rule also recognizes that at any point in time
outstanding commitments are of differing ages. Some will only have a
few days left during which a seller can deliver loans and some will
have just recently been executed. Accordingly, outstanding commitments
would begin to expire rapidly over the first few months of the stress
test. Thus, even if deliveries were made evenly over the course of each
individual commitment, the total deliveries would drop off quickly
within the first few months of the stress test. Also, mortgage lenders
do not enter into mandatory commitments for loans they are not
reasonably certain they have in the pipeline and these loans are
generally delivered within a few months. Loans under optional
commitments also tend to be delivered early, because the commitments
become outdated rapidly as the market changes and sellers negotiate new
agreements.
OFHEO recognizes that the assumptions suggested by Fannie Mae in
regard to both fill rates and delivery schedule are not necessarily
wrong or unreasonable. However, in the absence of any data
demonstrating the historical or current mix of outstanding commitment
types, differences in deliveries under different commitment types, mix
of loan types delivered under commitments, or the period of time over
which deliveries under commitments actually occur, OFHEO will use the
more conservative approach specified in the rule.
e. Mix of Loan Characteristics
Fannie Mae also recommended that OFHEO specify the mix of
characteristics for loans delivered under commitments based on the mix
of loans in an Enterprise's portfolio, rather than on the mix of recent
deliveries. Fannie Mae expressed concern that basing the mix upon
recent deliveries might weight one-time purchases of a particular loan
type too heavily.
As discussed in detail in NPR2 in response to a similar comment
from Freddie Mac on the ANPR,\66\ OFHEO has seen no evidence that the
mix in the current loan portfolio is a good proxy for the mix of loans
delivered under commitments. Neither has OFHEO seen evidence of a one-
time purchase so large that it would skew significantly or
inappropriately the mix of loans delivered over six months. Also, this
decision rule reflects recent changes in an Enterprise's business
decisions and, in this sense, is more sensitive to risk than basing the
mix on the total loan portfolio. Finally, the mix of loan
characteristics has a limited impact on the capital requirement,
because the Enterprises bear no interest rate risk on loans delivered
under commitments, which are all securitized. For these reasons, OFHEO
continues to view the recent deliveries as the best available indicator
of the mix of characteristics of loans to be delivered in the stress
test. Accordingly, this aspect of the commitments specification has not
changed in the final rule.
---------------------------------------------------------------------------
\66\ 64 FR 18165-18166, April 13, 1999.
---------------------------------------------------------------------------
f. Pair-off Fees
Fannie Mae also criticized the proposed stress test because it did
not account for pair-off fees that would be paid on undelivered loans
under mandatory commitments in the up-rate scenario. OFHEO has no data
from the Enterprises indicating when, how often, or in what amounts
pair-off fees are charged and no data indicating what percentage of
commitment agreements provide for the payment of pair-off fees. Given
the lack of these data, or even data indicating actual percentages of
loans delivered under commitments, OFHEO had no basis upon which to
include a credit for pair-off fees in the stress test and has not
modified the proposed rule to do so.
g. Data
Although the final regulation's commitments specifications are
little changed from those proposed, OFHEO views commitments as an area
that is worthy of additional study and, therefore, is considering
requiring the Enterprises to collect data about commitments that would
allow empirical analysis in this area. For example, if the Enterprises
had tracked delivery percentages and timing under commitments, a far
more precise model, such as is suggested in Fannie Mae's comments,
could be constructed. If these data had been tracked by commitment type
and length of term, an even more sophisticated model would be possible.
Such data and the analysis they would facilitate might provide OFHEO
the basis upon which to modify the specifications in the existing
commitments model or to develop a more finely-tuned model.
G. Interest Rates
Interest rates are a key component of the adverse economic
conditions of the stress test. The ten-year constant maturity Treasury
yield (CMT), as specified by the 1992 Act, provides the basis for the
severe interest rate stress in the stress test. The stress test also
incorporates a number of other interest rates, the levels of which will
determine the volumes of mortgage prepayments and defaults; the cost of
new debt issues and earnings on new investments; and rates paid or
earned on assets, liabilities, and derivative contracts.
The 1992 Act specifies the path of the CMT for ten-year securities
(ten-year CMT) for two interest-rate scenarios during the stress
period.\67\ However, for the determination of all CMT maturities other
than the ten-year CMT, the 1992 Act states only that they will change
relative to the ten-year CMT in patterns and for durations that are
reasonably related to historical experience and are judged reasonable
by the Director.\68\ For non-CMT interest rates, the 1992 Act simply
states that characteristics of the stress period that are not specified
will be determined by the Director, on the basis of available
information, to be most consistent with the stress period.\69\
Therefore, the final rule specifies the CMT yield curves and the spread
relationships between CMT series and other interest rates that will
determine the levels of all interest rates in the stress test.
---------------------------------------------------------------------------
\67\ 12 U.S.C. 4611(a)(2).
\68\ 12 U.S.C. 4611(a)(2)(D).
\69\ 12 U.S.C. 4611(b)(2).
---------------------------------------------------------------------------
[[Page 47753]]
1. Proposed Rule
In NPR2, OFHEO proposed that the required changes to the ten-year
CMT would occur in twelve equal monthly increments from the starting
point for the ten-year CMT, which is the average of the daily ten-year
CMT for the month preceding the stress period. As specified in the 1992
Act, the ten-year CMT would then remain at the new level for the last
nine years of the stress period.
The proposed rule also established the Treasury yield curve for the
stress period in relation to the movements in the ten-year CMT. In the
down-rate scenario, the rule specified an upward sloping yield curve
during the last nine years of the stress period. In the up-rate
scenario, the rule specified a flat yield curve for the last nine years
of the stress period, i.e., yields of other CMT maturities are equal to
that of the ten-year CMT.
The stress test must project the levels for a number of non-CMT
rates that affect the Enterprises' business performance. Some of these
key rates are the Federal Funds rate, London Inter-Bank Offered Rate
(LIBOR), Federal Home Loan Bank 11th District Cost of Funds Index
(COFI), and Enterprise Cost of Funds rates. The proposed rule
established these rates using Autoregressive Integrated Moving Average
(ARIMA) procedures, a statistical estimation technique for projecting
time series. The estimation is based upon each series' historical
spread to the CMT with a comparable maturity. In addition, NPR2
specified that in projecting the Enterprise Cost of Funds rates, the
stress test would add a 50-basis-point premium after month 12,
representing the additional cost of borrowing that might be anticipated
if an Enterprise were undergoing financial stress.
2. Comments and Responses
OFHEO received many comments on the NPR2 interest rate
specifications from the Enterprises, mortgage industry trade groups,
investment banking firms, and a major bank. Some comments criticized
the Treasury yield curve specifications, suggesting that other curves
would be more consistent with historical averages. Most commenters said
the specifications for non-CMTs were unnecessarily complex. Both
Enterprises objected to the use of the DRI Agency Cost of Funds rates,
suggesting that the quality control for that index was inadequate.
These comments are discussed in detail below.
a. Specification of the Flat Yield Curve in the Up-Rate Scenario
(i) Comments
The Enterprises and an investment bank criticized OFHEO's proposal
to transition to a flat yield curve in the last nine years of the
stress test in the up-rate scenario. These commenters agreed that the
yield curve historically tends to flatten or invert immediately after
upward interest rate shocks, but they asserted that the yield curve
resumes a more normal upward sloping shape during extended periods of
stable rates. Both Enterprises questioned OFHEO's analysis of
historical yield curve data and submitted studies supporting their
conclusions. More specifically, Fannie Mae stated that OFHEO
misdirected the analysis by assuming that yields would remain constant
during the last nine years of the stress test and that OFHEO based its
analysis on regression equations that were misspecified. The
Enterprises also argued that the flat yield curve would slow
prepayments inappropriately by eliminating any refinancing incentive.
Freddie Mac suggested that the flat yield curve distorts the cost of
new debt in the stress test by creating inappropriately high refunding
costs. Fannie Mae argued that by potentially increasing short-term
Treasury yields by more than the increase in the ten-year CMT, the flat
yield curve specification imposes more stress than Congress intended in
the 1992 Act. No commenter objected to use of the yield curves
specified in the down-rate scenario, although Freddie Mac stated that
the curve was steeper in the last nine years of the stress period than
suggested by historical experience.
(ii) OFHEO's Response
The 1992 Act includes two requirements concerning stress period
CMTs other than the ten-year CMT.\70\ First, the other CMTs must move
in patterns and for durations relative to the ten-year CMT that the
Director determines are reasonably related to historical experience.
Second, these movements must be judged reasonable by the Director. The
second requirement is more general, providing that the resulting yield
curves should be reasonable within the context of the stress test and
the overall purposes of the 1992 Act.
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\70\ ``Yields of Treasury instruments with other terms to
maturity will change relative to the 10-year constant maturity
Treasury yield in patterns and for durations that are reasonably
related to historical experience and are judged reasonable by the
Director.'' 12 U.S.C. 4611(a)(2)(D).
---------------------------------------------------------------------------
After reviewing the comments, OFHEO has determined that it should
not alter the yield curves specified in NPR2. As mentioned above, the
commenters agreed that yield curves tend to flatten when interest rates
increase sharply and tend to steepen when rates decline sharply. The
regulation reflects this general historical tendency in both interest
rate scenarios during the first year of the stress period. Because the
magnitude and speed of the stress test changes in the ten-year CMT
exceed historical experience, it is reasonable to project that yield
curve changes would be unusually large. OFHEO was also guided by the
requirement that the ten-year CMT remain constant during the last nine
years of the stress period. Such constancy is far different from any
historical period. OFHEO has determined that a constant yield curve
during the last nine years is the most reasonable and consistent
approach, and, as discussed in the preamble to NPR2, best ties capital
to risk.
To select the constant yield curves, OFHEO examined historical
average yield curves and observed that the curves were consistently
flatter the more ten-year CMT yields increased and consistently steeper
the more ten-year CMT yields decreased. Given the large size of the
yield changes in the stress test, OFHEO selected yield curves that
approximated the bounds of historical experience. OFHEO further
supported that choice with simple regression equations that illustrated
the pattern observed.\71\
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\71\ The constant terms in the regression equations were
misreported in the preamble to NPR2 as 0.86. The correct estimates
were 0.67 for the full sample and 0.66 for the estimation based on
quartile averages. However, the projections of yield curves under
stress test conditions were based on the correct coefficients.
Further, OFHEO determined upon review that the regression equations
were appropriately specified as described in footnote 148 in NPR2.
65 FR 18148, April 13, 1999.
---------------------------------------------------------------------------
Fannie Mae argued that the specified yield curves in both scenarios
are the most stressful ever observed. However, OFHEO's analysis of the
shapes of historical yield curves indicated that more severely sloped
yield curves have occurred than those that OFHEO chose for the stress
test. In periods where interest rates have declined sharply, yield
curves with slopes steeper than 0.77 were observed. In periods where
interest rates rose rapidly, yield curves have frequently inverted.
Although these yield curves have not persisted for periods of many
years, severe interest rate shocks have also not persisted.
It is important to note that, in addition to historical analysis,
the selection of the actual yield curves in the stress test also took
into account the role of interest rates in the stress test. In
[[Page 47754]]
this regard, consistent with the requirement in the 1992 Act that the
Director judge interest rates to be reasonable,\72\ it is appropriate
and reasonable within the context of a stress test to specify yield
curves that remain more stressful than the average yield curve.
Accordingly, OFHEO has selected curves that have been observed
frequently in the past, but, as applied in the regulation, are
unusually stressful for an extended period.
---------------------------------------------------------------------------
\72\ 12 U.S.C. 4611(a)(2)(D).
---------------------------------------------------------------------------
The Enterprises argued, in effect, that the flat yield curve adds
additional risk to their portfolios in the up-rate scenario of the
stress test by raising the cost of short term debt by a greater amount
and percent than the increase in the ten-year CMT. They seek an
approach that recognizes a discount for short-term debt, which would
lower the capital requirement in the up-rate scenario. OFHEO disagrees.
The 1992 Act does not suggest that other interest rates should not move
more than the ten-year CMT.
For all the above reasons, OFHEO has determined that the most
reasonable means of relating the yield curve to historical experience
recognizes the general direction of yield curve changes during changing
interest rate environments without attempting to fine tune that
historical analysis throughout the ten years of the stress period.
Accordingly, OFHEO has further determined that, given the design of the
stress test, a yield curve that transitions during the first year to a
flat curve for the last nine years of the up-rate scenario and to an
upward sloping yield curve for the last nine years of the down-rate
scenario best meets the dual requirements of the 1992 Act.
b. Specification of Non-Treasury Rates
(i) Use of ARIMA Methodology
Numerous commenters criticized the proposed use of ARIMA models to
project non-Treasury rates during the stress period. For a variety of
reasons, the commenters all concluded that ARIMA models were too
complex and inaccurate to be relied upon to project non-Treasury rates
in a stress test. The models were argued to result in volatile and
unpredictable projections that would be difficult for parties other
than OFHEO to replicate. Freddie Mac recommended that OFHEO project
non-Treasury yields based on the average spread over the appropriate
CMT for the period two years prior to the beginning of the stress test.
No commenter favored the proposed ARIMA approach to projecting non-
Treasury interest rates.
OFHEO agrees that a different method of modeling non-Treasury rates
is appropriate. The final rule, therefore, discontinues use of the
ARIMA models. Instead, OFHEO will use the average spread between each
non-Treasury rate and its comparable maturity CMT for the two-year
period just prior to the beginning of the stress test. This approach
presents several advantages over use of ARIMA models. First, it is
easily implemented, and replicable by parties other than OFHEO. Second,
it is far less likely to impose large, erratic and unpredictable swings
in interest rate spreads. Finally, it is consistent with the use of a
fixed specification of the Treasury yield curve, rather than a varying
curve based on a statistical model.
(ii) Proportional and Absolute Spreads
Several commenters suggested that OFHEO consider whether it was
more appropriate to project certain non-Treasury rates based upon the
historical spreads in basis points between those rates and the
corresponding maturity CMT than to project the rates based on their
historical proportional relationships.
For nonmortgage interest rates, OFHEO found that proportional
spreads correlated better historically than absolute spreads. However,
for mortgage rates in the stress test, which are calculated from two-
year averages of the Bloomberg indexes for conventional 30-year fixed
rate loans and conventional 15-year fixed rate loans, OFHEO found that
absolute spreads provided a better correlation.
For these reasons, the final rule continues to use proportional
spreads to determine all interest rate series in the stress test,
except mortgage rates. In modeling mortgage rates, the final rule bases
the calculations upon absolute spreads.
c. Data Sources
Both Enterprises commented that DRI McGraw-Hill's (DRI) Federal
Agency Cost of Funds, which is the series used in the proposed
regulation to calculate the Enterprise Cost of Funds during the stress
period, was inappropriate for that purpose. OFHEO also notes that the
DRI series has been discontinued since the publication of NPR2.
Because the DRI series was discontinued, OFHEO has specified a
different index for calculating the Enterprises' Cost of Funds. The
only commercially available index suitable for this purpose is the
Bloomberg Generic Agency Cost of Funds. As an alternative, OFHEO
considered developing its own index of the Enterprises' Cost of Funds.
OFHEO has determined that developing its own index is the preferable
option, because OFHEO has no control over the content, methodology,
quality and availability of the Bloomberg index. However, development
of such an index will take considerable time and OFHEO will, therefore,
utilize the Bloomberg index in place of the DRI index until OFHEO
develops a more appropriate index.
3. Yields on Enterprise Debt
a. Comments
A number of commenters, including both Enterprises, objected to the
proposed method for calculating the interest rates at which the
Enterprises issue new debt after the first year of the stress period.
The Enterprises' borrowing rate in NPR2 included the addition of a 50-
basis-point premium to the projected Agency Cost of Funds after the
twelfth month of the stress period. Some commenters suggested there
should be no premium at all on Enterprise debt costs. These commenters
suggested that the debt markets would react differently to an
undercapitalized Enterprise than to other undercapitalized businesses
for varying reasons, including the Enterprises' special Federal status
and the confidence that investors in the debt market would have in the
regulatory oversight of the Enterprises. Both Enterprises argued that
the premium should be applied to all non-Treasury interest rate series
rather than only to the Enterprises' debt costs. The Enterprises each
submitted studies from consultants that offered a number of reasons to
support eliminating the debt premium. Implicit in the Enterprises'
comments was an assumption that the economic conditions of the stress
period would affect other borrowers as much or more than the
Enterprises. One Enterprise suggested that the debt markets would not
require a premium, because investors would recognize that the 30-
percent multiplier for operations and management risk would never be
exhausted. To support these arguments, commenters submitted historical
analyses to show that when the spreads between Enterprise debt rates
and Treasury yields have widened, other non-Treasury debt spreads have
widened as much or more, even at a time when Fannie Mae had negative
net worth.
Commenters also pointed out that applying a fixed-debt premium at a
fixed point in the stress test does not take into consideration the
condition of the Enterprise at the start of the stress test. They
suggested that one year into
[[Page 47755]]
the stress test an Enterprise may appear financially strong to
investors and that a debt premium would not be demanded by the market.
The debt premium was also criticized for failing to distinguish between
premiums on long- and short-term debt. Commenters argued that the
markets always demand a larger premium on long-term debt.
b. OFHEO's Response
OFHEO does not agree with the assumption of commenters that
investors will be so confident that the Federal government would
support Enterprise debt that the debt market will ignore the financial
condition of the company. To incorporate such an assumption into the
stress test would amount to the modeling of an implied federal
guarantee of Enterprise debt. The ``implied'' guarantee is, at most, a
market perception and not a legal obligation of the Federal government.
There can be no assurance that Congress would act to prevent loss to
investors, and market perceptions, therefore, may change. Further, it
would be particularly inappropriate to include such an assumption in a
stress test designed to ensure that the government is never called upon
to deal with a default by an Enterprise. To do so would weaken the
regulatory structure on the grounds that the public perceives the
structure to be strong-an imprudent course for any regulator.
Similarly, OFHEO disagrees with the argument that the stress test
should assume that the market would not demand a premium because the
Enterprises have a financial regulator and are subject to stringent
risk-based and minimum capital standards. Although OFHEO anticipates
that its existence and the capital regulations it issues will create
public confidence that the Enterprises will continue to be adequately
capitalized and operated safely and soundly, OFHEO will not presume
that the mere existence of this regulatory structure would prevent a
deterioration in the market for an Enterprise's debt when the
Enterprise is undercapitalized. Among other things, the increased
regulation of the Enterprises has also imposed clearer capital
requirements and greater disclosure regarding their operations--a trend
that OFHEO expects to continue. It is, therefore, possible that
investors will be more sensitive to capital inadequacies at the
Enterprises than they were in the past.
OFHEO was not convinced by arguments that the market would not
demand a premium because investors would rely on the implied Federal
guarantee or the regulatory structure, and was not persuaded by
commenter's arguments, based on sparse historical data, that other
spreads would widen by as much or more than those of government
sponsored enterprises. Nevertheless, relevant historical data to
support a new debt premium are also sparse. There has been only one,
relatively brief, period of time in the early 1980s when one of the
Enterprises experienced financial stress approaching the magnitude
specified in the stress test. The only other similar event involved the
Farm Credit system in the mid-1980s. In addition, it is conceivable, as
some comments noted, that events that cause a widening of the spread
between the Enterprises' debt rates and Treasuries might also cause
other spreads to widen. These spreads have an important effect on the
value of hedging instruments and some Enterprise asset returns.
In light of these considerations, OFHEO has determined that there
is too little historical experience on which to determine definitively
whether other spreads to Treasuries would widen as much as the
Enterprises' spreads or to base an estimate of how much the
Enterprises' spreads would widen. Consequently, OFHEO has decided not
to include a premium on new debt in the final rule. The final
regulation does, however apply a 50-basis-point call premium to new
five-year callable debt. The cost of new debt is a likely area for
future research and for refinement of the rule, because assumptions
about these various other spreads may comprise an area of significant
risk to the Enterprises.
H. Property Valuation
In order to update origination LTVs to the start of the stress test
and to account for changes during the stress period, OFHEO proposed
property valuation methodologies for single family and multifamily
loans. Because these methodologies were different for single family and
multifamily loans, comments and responses related to property valuation
are discussed separately for single family and multifamily loans.
1. Single Family
In NPR1, OFHEO proposed to use its House Price Index (HPI) to
calculate property values for the purpose of determining current LTVs
for Enterprise loans as of the starting date of the stress test. For
this purpose, OFHEO proposed to use the HPI of the Census Division in
which the loan originated along with the related volatility parameters.
In NPR2, OFHEO proposed to determine house price growth rates during
the stress test using its HPI values from 1984 to 1993 for the West
South Central Census Division, the division in which most of the ALMO
benchmark states are located,\73\ along with the volatility parameters
for the Census Division in which the loan was originated.
---------------------------------------------------------------------------
\73\ The West South Central Division includes all of the ALMO
states except Mississippi.
---------------------------------------------------------------------------
The HPI utilizes a repeat transactions estimation process based on
a stochastic model of individual housing values. The indexes estimated
using this process represent a geometric mean. Along with the HPI,
OFHEO publishes the factors needed to adjust the indexes from geometric
to arithmethic means (the Goetzman correction), an adjustment needed
for some applications of the HPI.\74\ However, OFHEO proposed to use
the HPI without the Goetzman correction in the stress test.
---------------------------------------------------------------------------
\74\ A geometric mean of a group of n numbers is the nth root of
their product, whereas the arithmetic mean, which Freddie Mac uses
in its house price index, is the simple average of the numbers.
---------------------------------------------------------------------------
The 1992 Act requires that if interest rates rise by more than 50
percent of the average ten-year CMT for the nine months prior to the
start of the stress test, losses must be adjusted to account for
general inflation. The stress test proposed by NPR2 implemented this
requirement by increasing house prices by the amount the ten-year CMT,
after the upward shock in interest rates, exceeds the average ten-year
CMT for the nine months prior to the start of the stress period. This
amount is compounded over the remainder of the stress period for a
cumulative inflation adjustment. The adjustment is applied over the
last 60 months of the stress period.\75\
---------------------------------------------------------------------------
\75\ See section 3.4, Property Valuation of NPR2, 64 FR 18236,
April 13, 1999.
---------------------------------------------------------------------------
The comments related to the use of the HPI in the stress test and
comments on the inflation adjustment are discussed below.
a. HPI Issues
Comments related to the use of the HPI in the stress test focused
on four issues--(1) The use of a geometric index instead of an
arithmetic index; (2) the restriction of the database to loans
financing single family detached properties, where the loans were
eventually purchased or guaranteed by the Enterprises; (3) the HPI
volatility parameters used during the stress period; and (4) the
procyclical effect of the methodology on the capital requirement.
(i) Geometric Mean
The Enterprises objected to OFHEO's decision not to use the HPI
without the Goetzman correction for stress test
[[Page 47756]]
purposes. However, NAHB noted that, for the purpose of meeting the
requirements of the 1992 Act, OFHEO's index is superior to other house
price indexes, including the Conforming House Price Index published by
the Enterprises, which uses an arithmetic mean.
OFHEO continues to believe that a geometric index is more
appropriate for the stress test than an arithmetic index, primarily
because a geometric index approximates a median value, whereas an
arithmetic index results in an average value. Because housing values
are distributed lognormally (i.e., skewed to the right), the median is
a better measure of central tendency for a loan-level analysis, such as
that reflected by the single family default and prepayment model, than
the average. By definition, the average for a lognormal distribution
that is skewed to the right will always lie above the median because
the average in effect gives more weight than the median to
``outliers,'' in this case, loans that are experiencing appreciation
far in excess of the majority. Therefore, the average will always be
higher than the actual appreciation rates experienced by the majority
of the individual loans. A geometric index results in values that are
far closer to median and therefore gives far less weight to outliers.
For the purpose of a stress test, OFHEO does not think it is
appropriate to update property values using appreciation rates that are
higher than those experienced by the majority of loans. Consequently,
the final regulation continues to use the HPI without the Goetzman
correction.
(ii) HPI Database
(a) Comments
A number of other commenters asserted that the house price vector
used in the stress test is not stressful enough, resulting in losses
that are understated relative to the benchmark loss experience,
especially for low-LTV loans. These commenters noted that the house
prices in the HPI for the West South Central Census Division from 1984-
1993 evidence a 12 percent initial decline before increasing, while
Moody's, Fitch, and other rating agencies use at least a 30 percent
decline before increasing. They assert that this weaker decline in
house prices is attributable to the exclusion from the HPI database of
transactions involving single family homes that are not detached (i.e.,
condos, planned unit developments and 2-4 family homes) and the
exclusion of foreclosure sales. The result, in the opinion of some
commenters, is that the capital requirement is understated and biases
are introduced in favor of low-LTV loans and older loans, which result
in understated default rates. Some commenters who criticized the use of
the HPI recommended that OFHEO use a different house price vector, such
as one used by one of the rating agencies, and also calibrate single
family default and prepayments rates to the benchmark by LTV ratio.
(See further discussion of calibration to the benchmark loss experience
in III.I.1.g., Relating Stress Test Default Rates to the Benchmark Loss
Experience.)
Freddie Mac and Fannie Mae, in their reply comments, took issue
with the comment that the HPI is biased upward because foreclosure
sales are not included in the HPI database. Freddie Mac pointed out
that, although foreclosure sales are not included in the database, the
sale of the foreclosed property in an REO disposition is included if
such a transaction results in a mortgage that an Enterprise buys.
Freddie Mac further observed that the overall stringency of the stress
test depends on whether the default and severity models are
appropriately calibrated to the benchmark and that a more severe path
of house price appreciation would lower the calibration constant used
to ensure that the default and severity models produce credit loss in
line with the benchmark loss experience, rather than make the stress
test more severe.
(b) OFHEO's Response
OFHEO continues to believe that it is appropriate to use an index
based on Enterprise data rather than rating agency assumptions to
determine house price growth rates during the stress test. As noted in
the ANPR and NPR1, OFHEO believes that the direct correspondence of the
Enterprise database to the segment of the housing market served by the
Enterprises make that database a more appropriate basis for determining
a house price appreciation path for Enterprise loans during the stress
period.
OFHEO also believes that the HPI is the most appropriate index
available for establishing property values during the stress test,
notwithstanding the restriction of the database to transactions
involving single family detached homes. OFHEO restricted the database
to single family detached loans because it is the dominant mortgage
product and because the markets for PUDs, condos and 2-4 family homes
have different behavioral characteristics. The impact of their
exclusion is likely to be small because the Enterprises buy few of
these loans.
OFHEO does not believe that the lack of foreclosure sales in the
database makes the HPI unsuitable for use in the stress test. Even if
the data on which the HPI is based resulted in an upward bias to house
prices that understated default rates relative to the benchmark loss
experience, the calibration of the default and severity rates to the
benchmark loss experience would compensate for it.
(iii) Stress Test Volatility Parameters
To determine the path of house price appreciation during the stress
period, NPR2 proposed to use the HPI for the West South Central Census
(WSC) Division from the benchmark period (1984Q1 through 1993Q4), with
the volatility parameters for the Census Division in which a loan was
originated up to the start of and during the stress period. Although
one commenter appeared to support this approach, others expressed
concern that it would result in different capital requirements for
otherwise identical loans in different Census Divisions. The commenters
asserted that this would distort mortgage purchase incentives for the
Enterprises and result in inconsistent treatment of consumers and
inefficient economic outcomes. The Enterprises also expressed concern
that the NPR2 approach, involving quarterly updates to Census Division
volatility parameters, would make it difficult to anticipate the risk-
based capital requirement and incorporate it into their operations.
They urged OFHEO instead to apply fixed volatility parameters
associated with the West South Central Census Division during the
stress period.
The final regulation adopts the commenters' suggestionn to use the
fixed volatility parameters associated with the West South Central
Census Division. The final rule uses the West South Central volatility
parameters as published in the Third Quarter, 1996 HPI Report, both in
updating property values to the start of the stress test and in
projecting changes in property values during the stress period.
(iv) Procyclicality
A number of commenters argued that the use of OFHEO's repeat
transactions HPI to update LTV ratios for loans as of the start of the
stress test may result in volatility that may understate Enterprise
capital needs in times of house price ``bubbles'' \76\ and possibly
exacerbate house price declines. Higher levels of house price
appreciation result in a lower probability of negative equity
[[Page 47757]]
(and hence lower default levels), which results in a lower capital
requirement. (Conversely, lower levels of house price appreciation
result in a higher probability of negative equity and hence higher
default levels.) Thus, it was argued, the capital requirement would be
lower during boom years and higher during recessionary periods. The
commenters asserted that during periods of low or negative rates of
house price growth, higher capital requirements would constrain the
ability of the Enterprises to buy mortgages, potentially contributing
to further housing value declines. To reduce this procyclicality in the
capital requirement, the commenters recommended that OFHEO use a two-
year moving average of HPI values rather than the HPI value in a single
quarter to update LTVs to the start of the stress test.
---------------------------------------------------------------------------
\76\ ``House price bubbles'' refers to the tendency of the rate
of house price growth to accelerate before a decline.
---------------------------------------------------------------------------
In their reply comments, both Fannie Mae and Freddie Mac supported
the idea that required capital should be high when economic risks are
high. Fannie Mae agreed that use of a moving average would dampen the
effects of rapid house price movements while still ``relating capital
to broad-based and long-term risk.'' Freddie Mac did not support the
use of a two-year moving average, citing factors that would mitigate
excessive procyclicality. First, it was argued, booms and busts tend to
be regional rather than national phenomena, and the Enterprises'
portfolios are highly diversified, which limits their exposure to
regional downturns and upturns. Second, Freddie Mac asserted that the
Enterprises will manage their capital to provide stability in the
secondary market for residential mortgages through the business cycle.
Lastly, Freddie Mac noted that the minimum capital requirement and
discretionary reclassification authority of the Director will ensure
that the Enterprises maintain a minimum level of capital.
OFHEO did not adopt the commenters' suggestion to use a moving
average of HPI values in the final rule. While a moving average would
dampen both upward and downward short-term trends in home values and
allow longer-term trends to have greater influence, OFHEO believes that
the use of current LTVs determined by the HPI values in the quarter
preceding the start of the stress test makes the test more effective as
an early warning device. Smoothing the path of house price appreciation
by using a moving average would allow an Enterprise to delay building
capital needed to meet requirements of the stress test based on actual
house price levels at the start of the stress test.
b. Inflation Adjustment
(i) Comments
The Enterprises and several other commenters argued that specifying
an inflation adjustment based on the difference between the ten-year
CMT after the stress test interest rate shock and the average ten-year
CMT for the nine months prior to the stress test and applying the
inflation adjustment over the last five years of the stress period
results in inflation adjustments that are too low. The Enterprises
stated that house prices generally keep pace with inflation under
stress scenarios, and recommended that the inflation adjustment be 75
percent to 100 percent of the increase in the ten-year CMT, not just
the component in excess of a 50 percent increase in the ten-year CMT,
citing studies by consultants hired by Freddie Mac.\77\ The Enterprises
and some other commenters favored beginning the inflation adjustment as
soon as the ten-year CMT is 50 percent above its average yield of the
preceding nine months, rather than waiting until the last five years of
the stress period. Fannie Mae argued that the intent of the inflation
adjustment is that credit losses in the up-rate scenario should be
lower than credit losses in the down-rate scenario at least when
interest rates increase by more than 50 percent.
---------------------------------------------------------------------------
\77\ Macroeconomic Advisers estimated the impact on home prices
of the range of inflation outcomes using a structural model of
housing sector. See Macroeconomic Advisers, LLC, ``House Prices
under Alternative Interest Rate Paths'' (January 18, 1999). At the
request of Freddie Mac, Michael Darby analyzed the economic scenario
most consistent with the stress period and concluded that the
inflationary environment that would be most consistent with the
interest rate path described in the 1992 Act would result in an
inflation adjustment 75 percent as large as the increase in interest
rates. See Michael Darby, ``Consistent Macroeconomic Conditions for
a Risk-Based Capital Stress Test'' (June 6, 1997).
---------------------------------------------------------------------------
(ii) OFHEO's Response
The final regulation makes no change to the inflation adjustment.
The assertion that the adjustment should be 75 to 100 percent of the
total increase in the CMT is based upon hypothetical models and
conjecture regarding the macroeconomic nature of such interest rate
increases. These hypothetical models and presumed relationships among
variables would result in inflation adjustments that would greatly
reduce the credit stress in the up-rate scenario. As discussed above,
many commenters have asserted that house prices are not stressful
enough compared to those considered stressful by the rating agencies,
which specify house price drops of 30 percent of more.
The 1992 Act recognizes that high interest rate environments are
often characterized by high levels of general inflation that would
exert upward pressure on house prices and mitigate some of the price
decline that results from the interest rate shock. For this reason, an
additional inflation adjustment for large increases in interest rates
is required. However, this requirement should not be interpreted as
implying that house price growth rates should increase in the full
amount of the increase in interest rates. Economic conditions that
drive stressful scenarios may cause house prices to deviate from the
rate of general inflation for extended time periods. Typically, the
immediate impact of interest rate increases is to dampen housing
demand, which results in declining housing prices. Declining house
prices discourage new construction, but the supply adjustment proceeds
quite slowly as the existing housing stock deteriorates. The supply of
land cannot adjust, so higher interest rates would continue to be
associated with lower land values. Thus, it would not be unreasonable
to observe a prolonged period of time in which the price of housing
deviates sharply from other prices. For example, the crisis in the oil
markets in the early 1980's caused substantial house price declines of
approximately 12 percent in the West South Central Census Division
during a period when the Bureau of Labor Statistics Consumer Price
Index (CPI) rose by 19 percent. After housing prices in that area
turned upward in 1989 and rose through 1993, they were only two percent
higher than a decade earlier, while the CPI had risen 44 percent.
Lastly, an adjustment to house prices such as that recommended by
the Enterprises would negate the credit stress of the benchmark loss
experience. OFHEO believes that this is not consistent with
Congressional intent and does not agree that the purpose of the
inflation adjustment was to ensure that losses are greater in the down-
rate scenario than in the up-rate scenario.
2. Multifamily Loans
For multifamily loans, OFHEO did not propose to use the HPI or any
other repeat-sales or repeat-transaction index to update property
values because of the inadequacies of any available property valuation
indexes. To overcome this lack of a property valuation index, OFHEO
proposed to use an earnings-based method to update property values and
income. OFHEO proposed to base the property value on property net
operating income (NOI) divided by a capitalization rate, which
discounted
[[Page 47758]]
the expected earnings stream while holding property-specific
characteristics constant.
OFHEO proposed to update property NOI using expected rent growth
and vacancy rates. Rent growth was derived from the rent of primary
residence component of the CPI and multifamily vacancy rates were taken
from the rental property vacancy rate series published by the Bureau of
the Census (Census Vacancy Series). Because Enterprise purchases of
multifamily loans are heavily concentrated in Metropolitan Statistical
Areas (MSAs), MSA indexes were used, where available. However, the CPI
rent index is only available for one MSA in the ALMO region during the
benchmark period (1984-1993) and the Census Vacancy Series covering the
ALMO region were not available prior to 1986. Therefore, in order to
capture the economic conditions affecting multifamily loans in the ALMO
benchmark loss experience, OFHEO turned to non-governmental sources of
data published by the Institute for Real Estate Management (IREM).
OFHEO used statistical relationships between IREM and CPI data and IREM
and rental vacancy data to create government-equivalent series for the
ALMO benchmark region and time period. Volatility estimates for rental
rate inflation and vacancy rates were used to calculate the dispersion
of multifamily property values, in much the same way volatility
measures for the HPI series were used to measure dispersion of property
values for single family loans.
a. Comments
Numerous comments criticized the proposal to update property values
using the proposed capitalization rate model. Only Freddie Mac
commented upon the specific choice of indexes for the projection of
multifamily rents and vacancies in the stress test. Freddie Mac
criticized OFHEO's proposal to utilize the combined CPI and IREM rental
indexes as indicative of economic conditions in the benchmark region
and time period, citing the relative paucity of multifamily data from
the ALMO region in the relevant time frame. Freddie Mac noted that the
proposed rule created little stress for multifamily loans, because it
resulted in substantial increases in collateral values during the
stress period. Fannie Mae likewise noted that the proposed model
resulted in increases in property values, contrary to Fannie Mae's own
experience in the southern California recession from 1991-1995, when
property values declined significantly. Despite their criticisms of the
property valuation component of the multifamily model, neither
Enterprise suggested changing the method of computing rent growth or
vacancy rates for the benchmark region and time period. Instead, they
suggested other changes to the model, which included dropping any
updating of property values during the stress period.
b. OFHEO Response
The comments criticizing the proposal to update property values are
discussed in III.I.3.a.i., Negative Equity and Current LTV Variables,
but for present purposes it is sufficient to note that OFHEO has
decided not to update multifamily property values in the stress test.
Nevertheless, the rental and vacancy indexes continue to play a key
role in modeling changes in NOI and have a material impact on the debt
service coverage ratio, a key variable in the revised multifamily
default model. Because of the importance of these indexes in
determining the values for this variable, OFHEO believed it important
to consider certain modifications in the computation of these indexes,
as discussed below.
After additional analysis, OFHEO found a better proxy for the
rental growth rates in the ALMO benchmark region and time period than
the government-equivalent series created from IREM data. That series is
replaced in the final rule with the population-weighted (1990 Census)
average of monthly rent growth rates \78\ of Metropolitan Statistical
Areas (MSAs) in the West South Central Census Division. CPI indexes are
available for two Consolidated MSAs (CMSAs) and one MSA in that
region--the Dallas/Fort Worth CMSA, the Houston/Galveston/Brazoria
CMSA, and the New Orleans, MSA. OFHEO has found the Texas MSAs to be
more reflective and representative of the stressful real estate market
in the ALMO region during the benchmark period than the IREM rental
data.
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\78\ Due to the extreme volatility of monthly changes in MSA
rental indexes, monthly rent growth was calculated as the twelfth
root of the year over year change in the rental indexes for each
MSA. Due to different base years, population-weighted averages of
the resulting MSA rent growth rates were taken to compute benchmark
loss experience rent growth.
---------------------------------------------------------------------------
Because the rent growth and vacancy rates are used together in the
stress test to determine NOI, OFHEO further determined it necessary to
use a method consistent and compatible with the rent growth computation
to compute the vacancy rates for the ALMO benchmark region. Therefore,
in the final rule, ALMO benchmark region vacancy rates are modified
from NPR2 in much the same manner as the rent price indexes. Like the
corresponding rent price indexes, ALMO benchmark region vacancy rates
are calculated using the population-weighted (1990 Census) average of
annual vacancy rates for all the MSAs in the West South Central Census
Division. Vacancy rate data are available for the Dallas, Houston, and
Ft. Worth, Primary MSAs (PMSAs) and the New Orleans, San Antonio, and
Oklahoma City, MSAs for 1986 forward. To create vacancy rate data for
the ALMO benchmark region and time period for the first two years of
the stress test, the ratio of the rental vacancy rates of the ALMO
benchmark region and time period to U.S. rental vacancy rates for 1986
(16.8 percent versus 7.3 percent) was assumed to hold in 1984 and 1985.
That ratio was applied to the U.S. rental vacancy rate in 1984 and 1985
to estimate vacancy rates in the ALMO benchmark region in those years.
These changes to the stress test rent growth and vacancy rates make
the multifamily model more consistent with the single family model,
because both models now use the same Census Division as a proxy for the
property valuation indexes in the benchmark region and time period.
I. Mortgage Performance
In order to determine how mortgages would perform under the stress
test, NPR2 proposed econometric models to simulate conditional rates of
default, prepayment, and loss severity for each month of the stress
period.\79\ To reflect the significant differences in the nature of
single family loans and multifamily loans, NPR2 proposed somewhat
different models for single family and multifamily loans. Consequently,
the comments and responses related to mortgage performance are
discussed separately for single family loans and multifamily loans.
---------------------------------------------------------------------------
\79\ The term ``default rate'' is used hereafter in this
document to refer to ``conditional default rate,'' unless otherwise
specified. The term ``conditional default rate'' refers to the
percentage of loan principal outstanding at the start of a period
that will default during that period.
---------------------------------------------------------------------------
1. Single Family Mortgage Defaults and Prepayments
To account for the interaction of default and prepayment,\80\ NPR2
proposed jointly estimated models of default and prepayment for three
categories of loans. To reflect differing behavioral characteristics of
these loans, NPR2 proposed three separate pairs of default and
prepayment equations for
[[Page 47759]]
30-year fixed rate mortgages (30FRMs), adjustable rate mortgages
(ARMs), and all other types of single family products (Other SF
Products). All three models treat the default and prepayment decisions
as options, and they were jointly estimated using the multinominal
logit statistical estimation method. The explanatory variables used in
the proposed default equations for all three models were age, age
squared, LTV at origination, probability of negative equity, occupancy
status, and burnout.\81\ Product type was also used as a variable in
the Other SF Products Model to account for the different default
behavior of the different types of products. The explanatory variables
used in the proposed prepayment equations were age, age squared, LTV at
origination, probability of negative equity, occupancy status, burnout,
relative spread, the slope of the yield curve, season of the year
(average effect), and relative loan size. For the Other SF Products
Model, an additional variable, product type, was used to take into
account the differences in prepayment behavior of the various types of
products.
---------------------------------------------------------------------------
\80\ Default and prepayment represent options that borrowers
choose between when they stop making regular monthly payments on a
mortgage. The likelihood of one option being chosen affects the
likelihood of the other being chosen.
\81\ Season of the year and relative loans size were used in the
estimation of the default equations, but omitted in the simulation
to achieve average seasonal effect and average loan size.
---------------------------------------------------------------------------
In order to reasonably relate default rates to the benchmark loss
experience, OFHEO proposed to use a single calibration constant to
calibrate the default function to the benchmark loss experience, so
that under interest rates associated with the benchmark loss
experience, the stress test would project ten-year cumulative default
rates for a pool of loans with the characteristics of the benchmark
sample that are comparable to the ten-year cumulative default rates of
the benchmark loss experience. A similar calibration was made for loss
severity rates.
Comments on these models are discussed below by topic.
a. Modeling Approach
The Enterprises found the joint modeling approach to be appropriate
and ``essentially sound.''\82\ Although the Enterprises had specific
concerns about the models, they suggested that, rather than revising
their specification or reestimating them, OFHEO could address their
concerns by other model adjustments, discussed below in this section by
topic. A number of other commenters questioned the joint modeling
approach, primarily because it explicitly reflects the potentially
offsetting effects of interest rate and credit stresses. Some of these
commenters suggested that a better approach would be to evaluate the
capital impacts of credit and interest rate risk separately. GE Capital
and MICA expressed concern that OFHEO's model understates losses
relative to the benchmark, produces inconsistent loss rates in the up-
and down-rate scenarios, and permits the Enterprises to overcompensate
in hedging one type of risk to offset another type of risk.
---------------------------------------------------------------------------
\82\ According to Fannie Mae, ``the level of detailed
econometric modeling of loan performance is unmatched among risk-
based capital regulations applicable to financial institutions.''
---------------------------------------------------------------------------
GE Capital and MICA proposed two alternative approaches to address
their concerns, both of which involved elimination of the proposed
default and loss severity calibration constants, adding new LTV-based
calibration constants, and substituting Moody's triple-A regional home
price decline for the West South Central HPI during the stress period.
The first approach would calibrate the model to the benchmark using
interest rates associated with the down-rate scenario. The other would
calibrate the model using the interest rate path associated with the
benchmark loss experience with a small prepayment calibration for high
LTV loans.
OFHEO continues to believe that a joint approach to single family
mortgage performance is both consistent with statutory direction and
appropriate for regulatory purposes. The 1992 Act contemplates the
calculation of a risk-based capital requirement based on interest rate
and credit stresses experienced simultaneously. The sum of the effects
of each experienced separately is not the same as the effects of the
two experienced together. The 1992 Act also requires that stress test
losses be reasonably related to the benchmark loss experience. OFHEO's
model achieves this by calibrating stress test losses to the benchmark
loss experience using the interest rates of the benchmark period and
house price growth rates of the benchmark period in the West South
Central Census Division, which includes most of the states of the ALMO
region. Substituting the Moody's house price path for the house price
path of the benchmark period and calibrating the mortgage performance
models using an interest rate path other than that of the benchmark
period would sever the ``reasonable relationship'' of stress test
losses to benchmark loss experience. The final rule does, however,
eliminate the single calibration constants and apply LTV-specific
calibration.constants. These issues are further addressed by the
discussions that follow.
b. Data Issues
The models proposed in NPR2 were estimated using all or a random
sample of all historical data the Enterprises had available for loans
they purchased and retained or securitized in the years 1979-1995, with
origination years from 1979-1993.\83\ This dataset had certain
limitations. It did not, for example, include the last paid installment
date for Freddie Mac defaulted loans,\84\ or any data for loans
securitized under Fannie Mae's swap program. In addition, it did not
reflect loan performance for most of the 1990's. In spite of these data
issues and their relationship to some of the concerns expressed about
the default and prepayment models, commenters generally agreed that
OFHEO need not reestimate the models proposed in NPR2 using a more up-
to-date and more complete historical data set and should not further
delay the final rule to do so.
---------------------------------------------------------------------------
\83\ The ARM equation used all available data; the fixed-rate
30-year and other single family products models used ten percent
random samples.
\84\ In NPR2, OFHEO noted that information was not available
from Freddie Mac on the last-paid installment date for defaulted
loans in the historical data used to estimate the model and that the
date of disposition of a foreclosed property had been used for
Freddie Mac's loans. The last-paid installment date was used for
Fannie Mae, 64 FR 18174, April 13, 1999.
---------------------------------------------------------------------------
Since the comment period closed, the Enterprises have provided
updated and improved data to OFHEO. Working with this new data, OFHEO
determined that certain model shortcomings, some identified by
commenters and some by OFHEO, were best addressed using this more
recent dataset. Consequently, OFHEO reestimated the single family
models using ten percent random samples from a dataset comprised of
loans that were originated in the years 1979-1997 and acquired by the
Enterprises in the years 1979-1999. In addition to significantly
increasing the number of loan observations, the new dataset remedies
several data deficiencies noted in NPR2. The dataset includes the last
paid installment date for both Enterprises and Fannie Mae securitized
loan data from 1991-forward. OFHEO's testing of various model
specifications using this updated dataset revealed that several
variables that previously demonstrated explanatory significance were no
longer statistically significant predictors of default, and these
variables were dropped from the estimation of the model. In addition,
other specifications of the models were changed slightly to address
commenters' concerns. These changes are discussed below by topic.
[[Page 47760]]
See also III.I.1.q, Summary of Changes in this section.
c. Mortgage Age
The single family default and prepayment equations proposed in NPR2
specified the age variable as a quadratic function--that is, each
equation contained two continuous age-related variables, age and age-
squared. MICA and GE Capital suggested that the proposed treatment of
loan age results in the understatement of default rates on ``seasoned
loans'' (loans outstanding for a year or more).\85\ Using MICA data and
extrapolating what they characterized as ``benchmark loss experience
default rates for seasoned loans'' from information about the benchmark
loss experience published in NPR1, these commenters inferred that the
stress test default rates were understated relative to the benchmark
loss experience, especially for high LTV loans, both ``seasoned'' and
newly originated. They also pointed out that industry data shows
conditional default rates remaining constant or even continuing to rise
after a loan reaches 4.5 years of age, rather than conforming to the
shape of a quadratic function. Two other commenters suggested that
OFHEO use standard aging curves for mortgage default and prepayment in
its stress test instead of specifying age as a quadratic function.\86\
In contrast, Fannie Mae stated its belief that OFHEO's ``model should
capture the relative performance of both (seasoned and unseasoned)
loans.''
---------------------------------------------------------------------------
\85\ The commenters use the term ``seasoned'' as it is commonly
used in the trade to mean loans that are not newly originated,
rather than in the statutory sense of changes in LTV ratios over
time.
\86\ The commenters did not define ``standard aging curves.''
---------------------------------------------------------------------------
After considering the issue raised by the comments, OFHEO concluded
that a categorical mortgage age variable would account for age-specific
differences in conditional rates of defaults and prepayments in
Enterprise data better than the continuous variables, age and age
squared. Consequently, the final rule treats age as a categorical
variable with nine age categories-six that correspond to each of the
first six years of a loan's life (when defaults and prepayments tend to
change rapidly) and three additional categories representing loans aged
seven to nine years, ten to twelve years, and older than twelve years.
d. Relative Spread (Mortgage Premium Value)
In NPR2, OFHEO proposed to use relative spread--the difference
between the coupon rate on a loan and the current market rate, divided
by the coupon rate--as an explanatory variable in the prepayment
equations. Relative spread is a proxy for ``mortgage premium value,''
the value to a borrower of the option to prepay and refinance. Mortgage
premium value is an important factor in determining prepayment rates.
When the borrower's rate is higher than the market rates, there is an
incentive to prepay. OFHEO recognized in NPR2 that there is a
theoretical basis for also using mortgage premium value as a variable
in default equations. However, OFHEO did not include relative spread as
a variable in default equations, but relied instead upon the burnout
variable, which reflects whether a borrower has passed up an earlier
opportunity to refinance at favorable interest rates, to measure the
influence of interest rates on default.\87\
---------------------------------------------------------------------------
\87\ See 64 FR 18132, April 13, 1999.
---------------------------------------------------------------------------
(i) Comments
Both Enterprises asserted that the proposed default equations do
not adequately capture the influence of interest rates on the default
rate, leading to an overstatement of losses in the up-rate scenario.
According to the Enterprises, the proposed stress test does not capture
the historically inverse relationship between interest rates and
conditional default rates. That is, conditional default rates tend to
decline in rising interest rate environments and rise in declining
interest rate environments.\88\ Neither Enterprise recommended the use
of a mortgage premium value in the default equations, but both
Enterprises asserted that failure to take the ``mortgage value effect''
into account resulted in an overstatement of credit losses in the up-
rate scenario. Although they recognized that the burnout variable can
partially explain why borrowers with loan rates higher than current
market rates might be more likely to default than borrowers with loan
rates lower than market, the Enterprises believe that the burnout
variable does not adequately capture the relationship between defaults
and changes in interest rates. As an alternative to using mortgage
premium value as a variable in the default equations, Fannie Mae
suggested that OFHEO specify an earlier and larger inflation offset or
adjust up-rate default rates by a constant multiplicative factor of
0.7. Freddie Mac noted that precise measurement of mortgage value
effect is very difficult in the extreme up-rate scenario of the stress
test, but agreed that ignoring mortgage value effect resulted in very
conservative default rates in the up-rate scenario.
---------------------------------------------------------------------------
\88\ Freddie Mac attributes this phenomenon to two factors:
burnout and mortgage value. However, as Freddie Mac also points out,
their separate effects are difficult to disentangle. Burnout refers
to the adverse selection that occurs in a declining interest rate
environment as many borrowers who can qualify for refinancing do so,
leaving the remaining borrowers, many of whom cannot quality for
refinancing because of poor credit or poor financial condition, with
a higher conditional probability of default. In a declining interest
rate environment the mortgage will have a premium value (relative
spread will be positive). Borrowers who are able to prepay benefit
from doing so, and those who are unable to prepay will have a higher
conditional probability of default.
---------------------------------------------------------------------------
(ii) OFHEO's Response
The inclusion of a mortgage premium value (relative spread)
variable in default/prepayment models is consistent with a pure option
theory of borrower behavior. In any month, borrowers can be thought of
as having an option to default and an option to prepay. The decision to
exercise or not exercise either of those options would depend partly on
the mortgage premium value. The relevance of the mortgage premium value
is based on an implicit assumption that a borrower would be able to
replace the existing mortgage with a new one at current market rates.
That assumption is generally justified in the case of prepayments, but
not in the case of defaults. Accordingly, OFHEO decided not to include
a mortgage premium variable in the default equation.
OFHEO disagrees with the Enterprises' view that the relationship
between default rates in the two different interest rate scenarios is
inappropriate. Those differences reflect the combined effects of very
different prepayment rates and of different conditional default rates,
which are affected by the burnout variable and the inflation adjustment
to house price growth in the up-rate scenario. Each of these effects is
properly measured, consistent with statutory requirements. The
Enterprises' assertion that there are other ways that interest rates
should affect default rates is not adequately supported. Any
relationships between interest rates and default rates not accounted
for by the factors that are incorporated in the stress test may reflect
past correlations between interest rates and such factors as
unemployment rates or underwriting practices (which OFHEO has
determined should not be incorporated in the stress test) or
correlations between interest rates and inflation rates in a way that
is inconsistent with the specific provision of the 1992 Act describing
how the relationship between interest rates and default rates should be
accounted for.
[[Page 47761]]
e. Burnout
The ``burnout'' variable reflects whether a borrower has passed up
an earlier opportunity to refinance at favorable interest rates. It
captures the tendency of the most responsive and creditworthy borrowers
to prepay first, leaving a remaining sample of borrowers with a lower
prepayment probability and higher default probability. The burnout
function specified by OFHEO in NPR2 was a simple binary function; the
borrower either missed prepayment opportunities over the prior eight
quarters or did not.
(i) Comments
Commenters criticized the burnout specification as inadequate to
capture the complex relationships between the current LTV, the economic
environment, and the burnout phenomenon. In addition, commenters
asserted that a binary function can cause large and sudden increases in
conditional default rates on new loans in the quarter in which it is
introduced, resulting in significant variability in the capital
requirement. Fannie Mae attributed the sudden increases in conditional
default rates to the combination of the binary function of the burnout
variable and the large coefficient (weight) assigned to it. To remedy
this, Fannie Mae suggested that the impact of burnout on defaults
should be delayed until two years into the stress period and ``smoothed
out'' by phasing in its effect over eight quarters. Still others
recommended that OFHEO respecify the variable to phase in the burnout
effects over a range of interest rates and over a longer period,
eliminating the abrupt transition to burnout status that creates
potential variability of the capital requirement.
(ii) OFHEO's Response
The final rule does not respecify the burnout variable over a range
of interest rates or a longer period, or delay consideration of burnout
until two years into the stress period, as suggested by commenters. The
final rule does, for newly originated loans, phase in the effect of
burnout once it is detected. Burnout is detected if the market rate is
200 basis points below the coupon rate in any two quarters out of the
first eight quarters of loan life. Once burnout is detected, its effect
is phased in over the first eight quarters after origination by
multiplying the default and prepayment weights associated with burnout
by an adjustment factor less than one. The adjustment factor is zero in
the first two quarters of the loan's life, 25 percent in the third and
fourth quarters, 50 percent in quarters five and six, 75 percent in
quarters seven and eight, and 100 percent thereafter. For example, if
rates drop by 200 basis points for the two quarters immediately after a
loan is originated, that loan, if not prepaid, would be considered
burned out in the third quarter of its life. Rather than applying the
full effects of burnout suddenly, 25 percent of the default and
prepayment weights associated with burnout would be applied in the
stress test for those quarters corresponding to the third and fourth
quarters of the loan's life, 50 percent in the fifth and six quarters
of the loan's life, and so forth. This change will make the transition
to burned-out status less abrupt for newly originated loans.
f. Occupancy Status
Occupancy status is used as an explanatory variable in the single
family default and prepayment equations proposed by NPR2. However, the
proposed stress test uses a single coefficient that reflects the
average occupancy status across all loans, resulting in a specification
that investor properties compose the identical fraction of all types of
Enterprise mortgages, regardless of their characteristics.
This simplification was criticized by both Enterprises as not
reflective of reality. They noted that investor loans have
substantially lower LTV distributions than owner-occupied properties,
and that 2-4 unit properties, which were assigned to the owner-occupied
loan groups in the proposed regulation, exhibit characteristics more
similar to investor properties. They suggested that OFHEO use occupancy
status as a classification variable in forming stress test loan groups,
use the coefficients estimated from the models or assign investor-owned
properties a more appropriate multiplier, and allocate investor
properties to their proper LTV categories. They also suggested that
two-four unit properties and second homes be assigned to the investor-
owned loan groups.
OFHEO did not adopt the commenters suggestion to use occupancy
status as a classification variable because it would have doubled the
number of loan groups and increased the time required to calculate the
risk-based capital requirement significantly. However, the final rule
responds to commenters' concerns by adjusting the model coefficient for
each loan group by a fraction reflecting the actual percentage of
investor-owned loans in that loan group, rather than using a single
fraction reflecting the average occupancy status across all loans in
the Enterprise portfolio. The final rule adopts the suggestion to
assign 2-4 unit properties and second homes to the investor-owned
percentage.
g. Season of the Year and Loan Size
One commenter noted that season of the year and loan size \89\ were
used as explanatory variables in the estimation of the model, but not
in the stress test simulation, and that unemployment was not used as a
variable in either. The commenter urged OFHEO to re-estimate the model
without the season variable, include employment as a variable, and
conduct further research on the relationship between loan size and
probability of prepayment and default, stating that the size of the UPB
has proved an important factor influencing the likelihood of
prepayment.
---------------------------------------------------------------------------
\89\ OFHEO used relative loan size in estimating the model.
Relative loan size is the ratio of the original loan amount to the
average-sized loan purchased by the Enterprises in the same state
and in the same origination year.
---------------------------------------------------------------------------
As explained in NPR2,\90\ season of the year and relative loan size
were used in estimating the model but excluded in the simulations to
achieve an average size and average seasonal effect. Using a
specification for seasonality other than an average seasonal effect in
the default simulation would have created quarterly volatility in
default rates with no particular safety and soundness benefits. With
respect to relative loan size, the models OFHEO estimated for NPR2
demonstrated that larger loans tended to have faster prepayment speeds,
but the effect on default was small and inconsistent. Furthermore, loan
size is not needed to make the distinctions required by statute.
Weighing these factors, OFHEO concluded that using a specification
other than average loan size in default simulations would have resulted
in complexity not warranted by the additional benefit that would be
derived.\91\ Finally, OFHEO did not include the employment rate as an
explanatory variable because the stress test includes only
macroeconomic variables that are specified by the 1992 Act and
employment rate is not among them. Furthermore, as noted in NPR2, the
effect of macroeconomic variables such as unemployment are captured
through the process of relating the stress test to the benchmark loss
experience.\92\
---------------------------------------------------------------------------
\90\ 64 FR 18134-35, April 13, 1999.
\91\ Including relative loan size as a classification variable
would have resulted in a sevenfold increase in the number of loan
groups.
\92\ 64 FR 18135, April 13, 1999.
---------------------------------------------------------------------------
In the course of testing different specifications of the re-
estimated model, OFHEO found that these variables were
[[Page 47762]]
not statistically significant as predictors of default. Consequently,
in the final rule, seasonality and loan size are not used in the
estimation of the default equations. However, they remain significant
predictors of prepayment and continue to be used in estimating
prepayment equations. In the prepayment simulation, season of the year
continues to be omitted to achieve average seasonal effect, but
relative loan size is used as an explanatory variable to predict
prepayment.
h. Relating Stress Test Default Rates to the Benchmark Loss Experience
Many commenters, including the Enterprises, asserted that the
stress test overstates default rates on high-LTV loans; some commenters
asserted that it also understates default rates on low-LTV loans. This
effect was attributed to using a single calibration constant for all
single family loans rather than calibrating each LTV category to the
benchmark loss experience. One commenter suggested that a single
calibration constant will result in an incorrect forecast of credit
losses for any mix of business that differs from the mix in the
benchmark loss experience cohort of loans. The commenters recommended
calibrating to the benchmark loss experience by LTV category. In
addition, Fannie Mae suggested that OFHEO adjust default rates on
higher LTV loans to below those of the benchmark loss experience to
reflect improved underwriting.
The final rule addresses the commenters' concerns by calibrating
defaults to the benchmark loss experience by LTV category rather than
using a single calibration constant. The benchmark default rates by LTV
category to which stress test defaults are calibrated are set forth in
Table 4.
Table 4.--ALMO Benchmark Default Rates by LTV at Origination
------------------------------------------------------------------------
Default
LTV Category Rate
------------------------------------------------------------------------
0 LTV = 60 2.2%
------------------------------------------------------------------------
60 LTV = 70 3.5%
------------------------------------------------------------------------
70 LTV = 75 7.9%
------------------------------------------------------------------------
75 LTV = 80 9.4%
------------------------------------------------------------------------
80 LTV = 90 16.4%
------------------------------------------------------------------------
90 LTV 26.4%
------------------------------------------------------------------------
OFHEO did not adopt Fannie Mae's suggestion to adjust default rates
on higher LTV loans to below the benchmark loss experience in order to
reflect improved underwriting because, as explained in NPR2,\93\ to do
so would be inconsistent with the statutory direction to subject
current books of business to the credit stress of the benchmark loss
experience.
---------------------------------------------------------------------------
\93\ 64 FR 18118-18119, April 13, 1999.
---------------------------------------------------------------------------
i. Adjustable Rate Mortgages (ARMs)
(i) Comments
Some commenters asserted that the proposed ARM default model is
insensitive to payment shock and consequently understates defaults.
``Payment shock'' refers to the increased likelihood of default or
prepayment when the interest rate on an ARM loan increases and the
decreased likelihood of default or prepayment (sometimes called
``payment benefit'') when the interest rate decreases.
(ii) OFHEO's Response
OFHEO agreed with the commenters that adding a payment shock
variable would enhance the ARM model. In the course of making this
change, OFHEO discovered that a data issue needed to be addressed to
remove a potential bias in the re-specified ARM model. Specifically,
Freddie Mac has not been able to provide historical data with
sufficient computational details (such as identification of the ARM
index and rate or payment caps) for ARMs that defaulted or prepaid
before 1995, and Fannie Mae has captured its historical data in such a
way as to make the computational details for many of that Enterprise's
ARM products difficult to model and in some cases ambiguous. The lack
of computational detail in the available data results in an
underrepresentation of ARM defaults and prepayments among records with
these details. To address this issue, OFHEO has modified the treatment
of ARM loans in the final regulation as described below.
The final rule respecifies the ARM model for default and prepayment
rates as a multinomial logit model using an estimation dataset that
pools 10 percent random samples of long-term ARM (original terms of
more than 20 years) and 30FRM loans that were originated in the years
1979 through 1997 and acquired in the years 1979 through 1999. This
methodology is similar to the methodology used to model 15FRM loans,
balloon loans, and other single family mortgage products. This approach
allows the sample to be drawn from all available data with no
underrepresentation of defaulted and prepaid ARM loans.
The revised ARM model captures average differences in default and
prepayment performance for ARM products relative to 30FRM loans while
controlling for risk factors common to both types of loans. The
respecified ARM model includes the same set of explanatory variables as
the respecified 30FRM default and prepayment models, along with three
additional variables (described below) unique to ARMs. Some of the
explanatory variables common to both models, such as probability of
negative equity, burnout, and relative spread, were approximated for
ARM products because the information needed to replicate historical ARM
coupon rate adjustments and mortgage payment adjustments was not
available in the historical dataset. For example, the probability of
negative equity was based on the UPB amortized as if the loan rate were
fixed at the original rate, and relative spread and burnout were based
on the differences between the original loan rate and the current
market rate for 30FRM.
For these reasons, the effect on loan performance of subsequent ARM
rate and payment adjustments is reflected in the respecified ARM model
through the use of three additional explanatory variables unique to ARM
products--a binary ARM product variable (which simply indicates whether
the loan is an ARM product or not), a payment shock variable, and an
initial rate effect variable (which captures the loan performance
effects of ARM teaser rates in the first three years of a loan's
life).\94\ Computationally, the payment shock variable captures the
effects of the interaction between the ARM product variable and
relative spread. OFHEO believes that this serves as a reasonable proxy
for payment shock. Similarly, the initial rate effect variable captures
the interaction between the ARM product variable and the first three
loan age categories, representing loan age up to 3 years. All three new
variables are used in both the default and prepayment equations in the
respecified ARM model.
---------------------------------------------------------------------------
\94\ Even when market interest rates are not rising, teaser
rates (below market initial rates) can cause payment shock effects
in ARMs as the low initial rate adjusts to the market rate.
---------------------------------------------------------------------------
Because the payment shock variable is defined in terms of the
relative spread between the initial rate and market rate, the
coefficients (weights) for the payment shock variable can be
interpreted as ``ARM adjustments'' to the coefficients for relative
spread estimated from pooled 30FRM and ARM data. Similarly, the
coefficients for the initial rate effect variable can be interpreted as
ARM adjustments to the first three age coefficients, which are
[[Page 47763]]
also estimated from the pooled data. The ARM product variable
coefficient can be interpreted as a fixed effect that further
distinguishes ARM product performance from that of the pooled loans in
the dataset.
All variables in the final ARM model were found statistically
significant with reasonable interpretations for all variable weights.
The initial rate effect, which captures teaser rate effects, shows an
increase in the probability of default for ARMs during the first three
years of the loan term relative to the remainder of the loan term.
Finally, the payment shock variable predicts relatively higher ARM
default and prepayment rates in an up-rate scenario as monthly payments
rise, and relatively lower ARM default and prepayment rates in a down-
rate scenario as monthly payments decline.\95\
---------------------------------------------------------------------------
\95\ These effects are relative. For example, the model predicts
ARM prepayments will rise during a down-rate scenario, but not by as
much as 30FRM prepayments are predicted to rise in the same
scenario.
---------------------------------------------------------------------------
j. Credit Scores
Several Wall Street firms commented that the failure of the default
specification to take credit scores into account is inconsistent with
the goal of the stress test and suggested that OFHEO elicit proposals
from the Enterprises to incorporate credit scoring in the risk
calculation. Other commenters, including one of the Enterprises,
supported OFHEO's decision not to incorporate credit scores in its
mortgage performance models at the current time, but suggested that
OFHEO monitor the composition of mortgage credit scores to assure that
OFHEO's default projections continue to reflect the credit quality of
Enterprise mortgages.
The final regulation does not take credit scores into account.
Although borrower creditworthiness is not among the loan
characteristics required by the 1992 Act to be considered, as more data
becomes available on the predictive validity of credit scores, OFHEO
will consider whether credit scores can be taken into account in a way
that would improve the stress test.
k. Additional Risk Characteristics
Some commenters suggested that the failure of the model to
recognize the additional risk characteristics of loans such as
subprime, ``Alternative A,'' manufactured housing, and home equity
loans could result in inadequately capturing the risk in Enterprise
portfolios if these types of loans comprise a significant portion of
the portfolio. One commenter suggested adding a surcharge to the risk-
based capital calculation for second mortgage lending and subprime
lending because of higher levels of fraud and collateral valuation
issues encountered in such lending.
The final regulation makes no changes in the proposed regulation to
explicitly take into account unique features of such loans. However,
when OFHEO determines that a loan has such unusual features or risk
characteristics that it is essentially a different product from similar
loans for which a treatment is specified, and that the specified
treatment does not adequately reflect the risk to the Enterprises, the
Director has the discretion to treat such loans as new activities
subject to section 3.11, Treatment of New Enterprise Activities, of the
Regulation Appendix.
l. Aggregation of High LTV Loans
The proposed stress test groups all loans with LTVs over 90 percent
into the same LTV category. One commenter stated that this aggregation
resulted in a prepayment rate that is too high for the category and
suggested that distinctions should be made among 95 percent, 97 percent
and over 97 percent LTV loans. The final regulation does not adopt this
suggestion because there are too few observations of over 90 percent
LTV loans in the historical database to construct a reasonable model
for these high-LTV loans. In developing the stress test OFHEO sought to
achieve a balance between operational workability and precision.
Striking such a balance necessarily involves some grouping of sparsely
populated categories. When more data become available, OFHEO will
consider making finer distinctions.
m. Structured Mortgages
The proposed stress test does not differentiate between a first
mortgage made coincident with a second lien (together, a structured
loan) and one without. A number of commenters noted that failure to
distinguish loans based on this characteristic understates the true
credit risk and thus understates the required capital for structured
loans.\96\ Commenters suggested that the default frequency for
structured mortgages should be based on the current LTV of the combined
loans.\97\ However, Freddie Mac argued that, given current industry
data practices, there is no reliable way to distinguish an 80-10-10
mortgage \98\ from other 80 percent LTV mortgages and that the
increased credit risk of 80-10-10 loans is offset by improvements in
credit scores and other credit risk factors.
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\96\ Under NPR2, the first mortgage of a structured loan is
treated as an 80 percent LTV loan without taking into account the
second lien loan. However, in modeling the second lien loan, the
stress test takes into account the existence of the first lien loan
and assigns the second lien loan the combined LTV. The commenter's
suggestion implies that because the first mortgage is not also given
the combined LTV, the capital requirements for the structured loan
are understated.
\97\ The comment implies that the first lien mortgage should
also be assigned the combined LTV.
\98\ An 80-10-10 loan is a loan with an 80 percent LTV first
mortgage, a 10 percent LTV second lien, and a 10 percent down
payment.
---------------------------------------------------------------------------
OFHEO recognizes that there may be a risk distinction between a
first mortgage on a property that is also subject to a second lien
mortgage and one that is not. However, modifying the stress test to
capture that additional risk would require that the Enterprises be able
to identify those first mortgages that are also subject to a second
lien. Currently, the Enterprises are unable to do that in all cases.
Although no change has been made in the final regulation to respond to
the concern, OFHEO will require the Enterprises to collect combined
current LTV information for structured mortgages to analyze for
possible use in future modeling.
n. Product Categories
The Other Fixed-Rate Products Model proposed in NPR2 included five
categories of mortgage products to distinguish their different risk
characteristics--20-year fixed-rate mortgages, 15-year fixed-rate
mortgages, balloon loans, Government loans, and second lien loans.
However, in the re-estimation of the Model, OFHEO found that the
inclusion of the second lien loans as a separate product category
caused the coefficients associated with the 20-year fixed-rate
mortgages and the 15-year fixed rate mortgages to be statistically
insignificant. As a result, OFHEO eliminated the second lien data from
the re-estimation. In the stress test, loans with the second lien
product code will be assigned the coefficient weights from the Other
Fixed-Rate Products Model, using the government loan coefficient weight
for government loans and the balloon loan coefficient for non-
government loans. In addition, certain fixed-rate mortgage products
with variable payments over time (such as graduated payment mortgages
and growing equity mortgages) are no longer treated as ARMs as they
were in NPR2, because they are not affected by changes in market
interest rates. Like other non-standard fixed rate products, these
loans, many of which are past their scheduled payment adjustment
periods,
[[Page 47764]]
are assigned the balloon loan coefficient weight.
o. Prepayment Rate Levels
(i) Comments
A number of commenters, including the Enterprises, stated that the
stress test produces unreasonably low prepayment rates in the up-rate
scenario. One commenter suggested that, based on the commenter's
analysis of historical data, prepayment speeds in the up-rate scenario
should be roughly double those proposed by OFHEO. The commenter
attributed the difference to factors that OFHEO may not have taken into
account, such as the nonassumability of conventional mortgage loans
since 1985 and the long-run positive correlation of home price
inflation with rising interest rates. As a result, the commenter
supported a conservative prepayment speed assumption of 100-120 PSA
\99\ or 6-7 CPR \100\ in the up-rate scenario or, alternatively, the
adoption of a specific prepayment rate for the up-rate scenario. Other
commenters argued that prepayment speeds in the up-rate scenario were
implausible because termination rates (prepayment rates plus default
rates) would be below historical mobility rates.
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\99\ This measure of prepayment speed is derived from the
prepayment model of the Public Securities Association, (PSA), which
is an industry standard for measuring prepayment speeds.
\100\ CPR refers to ``conditional prepayment rate,'' a commonly
used method of expressing prepayment speeds on an annualized basis.
---------------------------------------------------------------------------
Some of the commenters attributed the low prepayment rates in the
up-rate scenario to the fact that the data used to estimate the model
are from a period when mortgage assumptions were common and interest
rates were generally falling. Hence, the commenters argued, the data
used are not representative of the mortgages currently owned by the
Enterprises (and, therefore, presumably insufficient to establish
prepayment rates for the up-rate scenario). These commenters suggested
that OFHEO calibrate prepayments to the benchmark loss experience and
adjust the prepayment rates upward in the up-rate scenario to reflect
the introduction of due-on-sale clauses in Enterprise mortgages and to
be more consistent with results from homeowner mobility studies. One
commenter noted that historical parameters will underestimate
prepayments in the future because technological improvements have
reduced the cost and inconvenience of rewriting and prepaying loans and
suggested that OFHEO correct for the underestimation. Some commenters
thought that prepayment rates in the down-rate scenario were too high,
and some thought they were too low. Freddie Mac thought prepayment
rates in the down-rate scenario were reasonable, noting that OFHEO's
probability of negative equity variable dampens the effect of large
refinancing incentives by capturing the effects of the falling house
price environment in the down-rate scenario and that prepayment rates
for loans with high original LTVs in falling house price environments
will be far lower than those of low LTV loans in good house price
environments.
Two commenters noted that the stress test does not produce
prepayment rates for the benchmark cohort that match actual historical
rates. One of those observed that the stress test produces prepayment
rates that are significantly higher than the mortgage industry
experience for the benchmark region and time period. The other
commenter noted that it is important for prepayment speeds not to be
overstated in the down-rate scenario or understated in the up-rate
scenario because the linkage of default and prepayment characteristics
associated with the joint modeling approach may ``inadvertently magnify
the dollars at risk.'' The commenter suggested further study of this
issue. Another commenter suggested that prepayments in the stress test
should be calculated based upon house prices growing at normal
historical levels, rather than using the house price path of the
benchmark loss experience.
(ii) OFHEO's Response
The final rule does not adopt the commenters' recommendations for
modifying the prepayment equations. Implicit in a number of these
comments is a belief that patterns of prepayment, like patterns of
defaults and losses, should be consistent with those of the benchmark
loss experience. However, the 1992 Act only requires that defaults and
loss severities be consistent with those of the benchmark loss
experience. Characteristics of the stress period other than those
specified by the statute, ``such as prepayment experience and dividend
policies'' are to be determined by the Director ``on the basis of
available information, to be most consistent with the stress
period.\101\ OFHEO's approach, which reflects prepayment patterns based
on all available historical data, is appropriately conservative. OFHEO
believes that, in order to represent the interest rate risk of the
Enterprises realistically, the stress test simulation of prepayments
should reflect overall historical prepayment patterns rather than
reflecting only borrowers' prepayment behavior associated with the
benchmark loss experience. Historical patterns have evolved over time
and take into account more recent patterns of prepayment, which are
more sensitive to interest rate changes than the prepayments of the
benchmark loss experience.
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\101\ 12 U.S.C. 4611(b)(2).
---------------------------------------------------------------------------
With respect to concerns about low prepayment speeds in the up-rate
scenario, OFHEO believes that scenario represents an unprecedented
combination of events--a severe nationwide recession combined with high
interest rates. Borrowers would have no incentive to prepay unless they
moved, but mobility rates would be unusually low. The cost of switching
to a mortgage with a much higher interest rate would greatly discourage
moving, and limited job availability would provide little incentive.
Similar conditions, though on a lesser scale, occurred nationwide
during the early 1980s. Turnover rate estimates provided by Salomon
Smith Barney in its comment show an average annual rate of 4.3 percent
in 1981-1983. Given the more severe conditions in the stress test, the
slightly slower prepayment speeds generated by the stress test model
are quite reasonable.
Similarly, the commenter's concern about data incorporating
assumable loans is misplaced. The Enterprises' historical data from
before 1986 is a relatively small portion of the overall dataset
because comparatively few loans were purchased from those origination
years, and the Enterprise data are incomplete. Furthermore, mortgage
rates in the early 1980s were unusually high, so assumability would not
have had a large effect on prepayment. The dataset contains few loans
originated in 1979. Any small effect on the results may be offset by
the unavailability of ARM and balloon loans in the early origination
years. Borrowers who expect to prepay more often select these loan
types, which tends to lower prepayment rates on 30-year fixed-rate
loans, but that effect is absent from early loan data.
p. Seasoned Loan Purchases
The stress test proposed in NPR2 made distinctions among loans
based on their age through the age variables and their changes in LTVs
(by amortizing mortgage balances and updating property values), but
made no distinction between loans purchased or guaranteed by an
Enterprise shortly after their origination, and loans purchased or
guaranteed after having been held for a period of time by the
originator.
Freddie Mac criticized the lack of distinction between loans
purchased or
[[Page 47765]]
guaranteed just after origination and ``seasoned purchases,'' (loans
purchased or guaranteed when they are at least 12 months old). Freddie
Mac stated that its ability to screen loans with ``substandard
performance'' from seasoned purchases lowers their risk relative to
loans purchased near the time of origination and suggested that OFHEO
identify seasoned purchases as a separate category and, ``based on
analysis,'' reduce their defaults in that category by 30 percent
relative to loans having otherwise similar characteristics.
In the absence of any empirical evidence that a reduction in
default rates is appropriate for seasoned loan purchases, and in view
of the increased complexity that would result from adding another data
element, the final rule does not adjust default rates downward for
seasoned loan purchases. However, should credible evidence become
available in the future that demonstrates that there is a significant
difference between the default rates for seasoned loan purchases and
the default rates for newly originated loan purchases, OFHEO will
consider whether the additional complexity that would result is
warranted.
q. Summary of Changes
In the final rule, the following changes are made to the proposed
single family default and prepayment models:
The models are reestimated using a more recent and
complete dataset.
A categorical age variable replaces the continuous age and
age squared variables
Investor-owned fractions are calculated for each loan
group and used to adjust the investor-owned coefficient.
Season of the year and relative loan size are dropped as
explanatory variables in the estimation of default equations.
Default rates are calibrated to the benchmark loss
experience by LTV category.
The ARM model, which has been respecified and reestimated
on a data set of pooled 30FRM and ARM loans, captures the average
effects of payment shock and other performance factors relative to 30
FRM loans while controlling for risk factors common to both types of
loans.
2. Single Family Loss Severity
NPR2 proposed to calculate loss severity during the stress period
as a percentage of the defaulting principal balance at the time of loan
default. Three components of loss severity were considered--loss of
loan principal, transactions costs, and funding costs. Loss of loan
principal is the Real Estate Owned (REO) sale price less the loan
balance, based on normal loan amortization, at the time of default.
Transactions costs comprise foreclosure/legal costs, property holding
and disposition costs, and for sold loans, four months of interest at
the security pass-through rate. Funding costs, the Enterprises' cost of
funding a loan between the time of default and sale of the foreclosed
property, were captured by discounting all costs and revenues based on
time of receipt during the foreclosure/REO disposition process.
NPR2 proposed an econometric model to estimate loss of loan
principal, fixed parameters for transactions costs and time intervals
for determining funding costs, and funding rates based on stress period
interest rates. The econometric model, estimated using all available
historical data for loans entering REO status, calculates the loss of
loan principal as a function of median house price appreciation rates
reflected by the HPI, and house price volatility. The model includes a
single calibration constant, to produce results consistent with the
ALMO benchmark loss experience.
In the proposed stress test, property holding and disposition costs
and foreclosure/legal costs are based on averages from all available
data on Enterprise REO properties. The four months of loan interest the
Enterprises must pass through to MBS investors for defaulted loans is
calculated at the MBS passthrough rate. Funding costs are determined by
discounting all loss severity elements by the six-month Federal Agency
Cost-of-Funds rate to produce the present value of each element in the
month of default. The time intervals used in the discounting process
are based on benchmark REO loans.
a. Comments
Commenters criticized the complexity of the proposed methods for
calculating the loss of loan principal and funding costs, the fact that
the approach did not consider pre-1987 Fannie Mae loss severity data,
the calibration of the loss of loan principal rates to the benchmark
loss experience using a single constant term rather than by LTV
category, and the inconsistent treatment of the components of loss
severity in their relationship to the benchmark loss experience. (Only
loss of loan principal and the timing of loss severity revenues and
costs were based on the benchmark loss experience.)
The Enterprises suggested that OFHEO extract loss of loan principal
estimates and funding costs directly from the benchmark loss experience
and use those in the stress test. They suggested (1) extracting loss
severity rates for three LTV ranges directly from the benchmark loss
experience, (2) subtracting from the resulting loss rates benchmark
funding costs, (3) making adjustments for pre-1987 Fannie Mae REO data
(which Fannie Mae has only recently made available), (4) adding back
new fixed funding costs (rather than using the present value approach
used to identify the benchmark loss experience) based on the interest
rate scenario (down- or up-rate) and relative LTV, and (5) make
specified adjustments for loan age and product type, also considering
LTV.
GE Capital and MICA criticized OFHEO's approach to loss severity in
the context of broader concerns about stress test mortgage losses being
lower than those implied by the ALMO benchmark loss experience,
inconsistency between loss rates in the up- and down-rate scenarios,
and the offsetting of some credit stress by interest rate stress. To
eliminate concerns about inconsistency between the interest rate
scenarios and the offsetting of credit stress by interest rate stress
they proposed an approach to loss severity rates that would be
insensitive to differences in the two interest rate scenarios. To
address concerns about overall mortgage losses, they proposed using LTV
category-specific calibration constants in the econometric model. They
proposed a calibration process that substituted the Moody's AAA
regional home price decline and an alternative interest rate path for
the benchmark house price and interest rate paths. Details of their
proposal for mortgage performance modeling are summarized earlier in
III.I.1.a., Modeling Approach.
b. OFHEO's Response
Upon review of the approach included in NPR2 and the related
comments, OFHEO determined that the modeling of loss of principal
balance could be greatly simplified. While the final regulation does
not adopt the commenters' specific suggestions, it modifies the
calculation of loss of loan principal and reduces its variability.
Rather than using an econometric model to estimate loss of loan
principal calibrated to the benchmark loss experience, the final rule
specifies loss of loan principal as a function of median house price
appreciation rates reflected by the HPI, and the average ratio of
actual sale prices of benchmark REO to values based on projected HPI
changes. The final rule eliminates use of the HPI volatility
parameters, and since it directly relates loss of loan principal
[[Page 47766]]
to the benchmark loss experience, requires no model calibration.
The final rule continues to apply the present value approach
proposed in NPR2 to determine funding costs. OFHEO does not agree that
funding costs should be fixed, since they would not be consistent with
the widely varying interest rate conditions associated with the two
stress test interest rate scenarios. OFHEO believes the funding costs
should be directly determined by stress test interest rates.
The final rule continues to apply NPR2 approaches to transactions
costs and the time intervals used to determine funding costs. However,
as a result of including previously unavailable Fannie Mae data on
foreclosure costs in the calculation of average historical REO holding
and disposition costs, the average foreclosure costs decreased from 5
percent to 3.7 percent and the REO holding and disposition costs
increased from 13.7 percent to 16.3 percent.
As discussed earlier in III.I.1.a., Modeling Approach, the 1992 Act
contemplates stress test results that reflect the interaction of
interest rates with mortgage performance. OFHEO believes the
differences in mortgage performance in the two stress test interest
rate scenarios are consistent with the 1992 Act.
3. Multifamily Loan Performance
NPR2 utilized two multifamily default models and five multifamily
prepayment models to capture the behavior of loans purchased under
different programs and at different stages in their life cycles. The
models were estimated using historical data through 1995 on the
performance of Enterprise multifamily loans. NPR2 proposed one default
model for ``cash'' programs and another for loans acquired under
``negotiated'' transactions (NT loans). The proposed prepayment models
allowed for appropriate distinctions between fixed- and adjustable-rate
loans, between fully-amortizing and balloon loans, and between loans
that are within yield maintenance or prepayment penalty periods (i.e.,
periods during which restrictions and/or penalties for prepaying a loan
apply) and those that are not. The models also provided for some
balloon loans to survive beyond their stated maturity dates. All of the
multifamily default and prepayment models were estimated with
historical rent and vacancy rates. Simulations were based upon rates in
the ALMO benchmark loss experience to create stress test conditions. To
determine loss severity on multifamily cash loans, NPR2 used average
cost and revenue components from all historical multifamily real estate
owned (REO) from which severity data was available, which consisted of
Freddie Mac loans originated in the 1980s. On NT loans that included
repurchase agreements, the loss severity rate was set at an historical
rate adjusted for the seller/servicer claim rate on 90-day delinquent
loans and was set on FHA loans at three percent of UPB.
a. Multifamily Default Model
The proposed rule used the following variables to determine default
rates in the cash model: \102\
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\102\ Because the NT model has been dropped from the final rule,
it is not described. See 64 FR 18136-18139, April 13, 1999, for a
description.
---------------------------------------------------------------------------
Joint Probability of Negative Equity and Negative Cash
Flow--Used to capture the probability of a particular loan incurring
concurrent negative cash flow and negative equity.
Mortgage Age and Age Squared--Used to capture change in
the risk of default as loans age.
Program Restructuring--Used to capture difference between
default risk of original multifamily programs and current, restructured
programs.
Balloon Maturity Risk--Used to capture the added risk of
default as the balloon maturity date approaches.
Value of Depreciation Write-offs--Used to capture effect
on default rates of the value of certain tax benefits.
Many commenters addressed the methodology proposed to calculate
multifamily loan defaults. Some of these comments expressed concern
that the multifamily default levels not be so high as to impact
negatively upon the Enterprises' low income housing programs and their
ability to meet housing goals. Other comments viewed the multifamily
model as insufficiently stressful and suggested major modifications to
avoid creating perverse incentives and anomalies in the final rule.
Others suggested that the proposed rule should take into consideration
the differences between Fannie Mae's Delegated Underwriting and
Servicing (DUS) loans and loans from other programs. A significant
number of comments also discussed the appropriateness of specific
variables proposed to determine default rates. These comments and
OFHEO's responses are summarized below by topic.
(i) Negative Equity and Current LTV Variables
A primary concern of numerous commenters was the methodology in the
proposed rule for updating property values from loan origination
through the stress period, which affected the Joint Probability of
Negative Equity and Negative Cash Flow variable (JP) and its balloon-
maturity counterpart (BJP). The model established current property
values by projecting the net operating income of each property and
capitalizing these cash flows to project price changes for the
collateral properties. The capitalization rates that were used to
determine property values were based upon ten-year constant maturity
Treasury yields.
Commenters criticized this method of capitalizing the net operating
income as inappropriate for a number of reasons. Some commenters
suggested it resulted in large increases in property values in the
down-rate scenario in contrast to the commenters' historical
experience. Some commenters argued that any realistic capitalization
rate model should take into consideration numerous factors other than
current interest rates, such as local housing inventory and the
marketability of particular neighborhoods. Furthermore, commenters were
concerned that the proposed methodology incorporates implicit
assumptions about economic parameters (such as variance, covariance and
distribution of rents, vacancy rates and property values) that were
untested, but had significant impact on default rates. Largely as a
result of these concerns about the capitalization rate model, all
commenters to address the issue suggested that OFHEO find an
alternative to the JP variable.
After considering these comments and further analyzing the NPR2
approach, OFHEO decided to eliminate the calculation of the probability
of negative equity from the multifamily model, thereby eliminating the
JP and BJP variables and the need to update property values throughout
the stress test. OFHEO concluded that the capitalization rate
estimation proposed in NPR2 was not sufficiently robust, given the
significant impact it could have on multifamily default rates. Because
the probability of negative equity comprised part of the JP and BJP
variables, those variables could not be used and the model in the final
rule replaces JP and BJP with variables related to property cash flow,
property value, and balloon risk.
The first of these variables is the natural logarithm of the
current debt-service-coverage ratio (current DCR).\103\
[[Page 47767]]
Current DCR is the ratio of the net operating income on the property to
the debt-service payments. Current DCR is updated in essentially the
same way as in NPR2 but with a newly-constructed rent and vacancy rate
series. The second is an Underwater DCR indicator variable (UDCR),
which indicates that property cash flow is negative because current DCR
has declined below 1.00. The third is the natural logarithm of LTV at
loan origination or, if origination information is unavailable, at
Enterprise acquisition (LTV).\104\ The fourth is a balloon maturity
flag or indicator (BM) that indicates a balloon loan within twelve
months of maturity.
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\103\ OFHEO used the log transformation on DCR and LTV to
capture the non-linear effects of these variables. In other words,
the incremental effect on the risk of default of a change in DCR
(LTV) was found to be greater at low DCR (high LTV) than at high DCR
(low LTV).
\104\ See supra note 103.
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In combination, current DCR, UDCR, and LTV capture essentially the
same mortgage performance factors the JP variable was designed to
capture--the effects of negative equity and negative cash flow on
default probability. Current DCR captures the expected inverse
relationship between debt-service-coverage ratio (net operating income
relative to mortgage payment) and default risk. Larger surpluses of net
operating income over the amount required to service debt represent
larger borrower cushions to weather possible increases in vacancy rates
arising from stressful economic conditions, such as the stress test.
UDCR captures the additional risk of default when current DCR is
negative. LTV captures the lower risk of default associated with
greater borrower equity early in the life of the loan. Larger amounts
of borrower equity at origination or acquisition appear to serve as a
cushion in delaying possible negative equity in situations of property
value deterioration caused by any number of primarily local or regional
phenomena.\105\
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\105\ For loans missing origination LTV, acquisition LTV is
used. If both are unavailable, 80 percent and 90 percent,
respectively, are used for New Book and Old Book loans. These
figures represent the mean origination/acquisition LTV of loans with
such data.
---------------------------------------------------------------------------
The fourth variable, a balloon maturity flag or indicator (BM) has
taken the place of the BJP variable. It captures additional risk of
default, resulting primarily from the borrower's inability to refinance
during the twelve months prior to balloon maturity. In the final rule,
conditional default rates reflect higher risk in the twelve months
prior to balloon maturity as a result of the balloon maturity flag, but
balloon loans are not extended at maturity as they were in NPR2.\106\
Although OFHEO realizes that the Enterprises commonly permit balloon
term extensions to qualified borrowers, particularly when the market
rate of interest exceeds the original note rate and a reversal of the
rate trend is expected in the short term, OFHEO also finds it
inappropriate to model this practice in the stress test given the
restrictions on new business imposed by the 1992 Act. Accordingly, and
consistent with the procedure for single family loans, in the final
rule, multifamily balloon loans which mature during the stress test
will pay off at maturity.
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\106\ In NPR2, loans already past their maturity dates at the
start of the stress test were extended three years and loans not yet
past their maturity dates at the start of the stress test were
extended five years. In both cases, the remaining loan balance was
amortized at the then-current market interest rate over the original
amortization term.
---------------------------------------------------------------------------
OFHEO determined that the definition of the term ``seasoning'' in
the 1992 Act must be applied differently to multifamily loans than to
single family loans.\107\ The definition appears to have been crafted
to apply only to single family loans, because it defines ``seasoning''
as the change in LTV of mortgage loans based upon changes in a specific
single family house price index or another equivalent index of OFHEO's
choosing. At this time, there are no indexes of multifamily property
values available that meet the standards of quality, authority, and
public availability in the 1992 Act. Therefore, in NPR2, OFHEO defined
an equivalent index of multifamily property values imputed from
existing rental and vacancy indexes in combination with the
capitalization rate model discussed above. However, OFHEO is now
persuaded by the commenters not to use this approach. Accordingly, the
final rule does not attempt to adjust LTV for multifamily loans
directly as it does for single family loans. Rather, to account for
differences in seasoning among multifamily loans, the stress test
updates DCR over time.
---------------------------------------------------------------------------
\107\ The 1992 Act defines ``seasoning'' at 12 U.S.C.
4611(d)(1). The Act provides that ``the Director shall take into
account * * * differences in seasoning of mortgages * * * the
Director considers appropriate.'' 12 U.S.C. 4611(b)(1).
---------------------------------------------------------------------------
The seasoning requirements of the 1992 Act are intended to require
OFHEO to take into account the impact of changes in the housing market
on mortgage losses.\108\ Congress recognized that changes in house
prices, as measured by widely available and reliable indexes, provide
an important measure of the direction of the single family housing
market. However, the 1992 Act also requires OFHEO to take into account
differences in types of mortgage loans,\109\ and applying single family
seasoning to multifamily loans would not take into account the
important differences between these loan types. Because multifamily
loans are commercial rather than residential loans, updating property
DCR provides a good measure of the impact of changes in the multifamily
housing market (and, therefore, of ``seasoning'') on multifamily
defaults. Therefore (and in contrast to single family lending, where
DCR is not applicable), in multifamily lending, change in DCR is the
most direct determinant of the continuing viability of a loan.
---------------------------------------------------------------------------
\108\ 12 U.S.C. 4611(b)(2).
\109\ ``[T]he Director shall take into account appropriate
distinctions among types of mortgage products * * * the Director
considers appropriate.'' 12 U.S.C. 4611(b)(1).
---------------------------------------------------------------------------
OFHEO has determined that the intent of the statute to take both
seasoning and product differences into account is best effected as to
multifamily loans by updating DCR through the stress period using the
government indexes that best represent rent growth and vacancy rates
from the ALMO benchmark region and time period.
(ii) Use of Actual Debt-Coverage Ratio
The Enterprises commented that OFHEO should use actual data on
income and expenses from annual operating statements along with
mortgage-payment information to establish the DCR of multifamily
properties as of the start of the stress test. OFHEO agrees that actual
data is preferable to the process proposed in NPR2 of updating
origination DCR using historical rent growth and vacancy rates to
impute net operating income as of the start of the stress test. The
final rule is modified accordingly. Thus, for multifamily loans that
have property-level operating statements, the most recent available
actual net operating income figures from these statements will be
divided by the current mortgage payment and the resulting DCR will be
reported in the Risk-based-capital Report, to be used to establish DCR
immediately prior to the stress period.
For properties for which the Enterprises at present lack annual
operating statements, the stress test uses origination DCR as DCR
immediately prior to the stress period. If origination data is also
lacking, the stress test uses acquisition DCR as DCR immediately prior
to the stress period. If both origination and acquisition data are
lacking, the final rule specifies a DCR immediately prior to the stress
period of 1.10 for Old Book loans and 1.30 for
[[Page 47768]]
New Book loans.\110\ OFHEO anticipates that these treatments are
sufficiently conservative to cause the Enterprises to begin collecting
accurate DCR data on all multifamily loans for which it is possible to
do so. If OFHEO finds these treatments not to be sufficiently
conservative for that purpose, it will reconsider the appropriate DCR
levels for loans with missing DCR data.
---------------------------------------------------------------------------
\110\ New Book and Old Book loans are discussed infra, 3.a.v.,
Use of Two Default Models.
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(iii) Age and Age Squared Variables
Only the Enterprises commented directly upon the inclusion of the
two age variables, age and age squared, in the default model. Although
neither Enterprise recommended specifically that these variables be
eliminated from the model, neither included them in its list of
recommended variables. Freddie Mac suggested that the age variables are
likely substituting for other variables or capturing measurement
problems and are unlikely to be related to the aging effects that they
are intended to capture. Fannie Mae commented that the age variables
increase default rates to an unexpected degree. As an example, Fannie
Mae suggested that a 13 percentage point difference in ten-year default
rates is too great between a cash 80 percent LTV, 1.25 DCR, 15-year,
balloon loan that is newly originated and the same loan that is four
years old.
OFHEO disagrees with the Enterprises' criticisms of the age
variables and has retained them in the multifamily model because they
are highly reliable predictors of default. Additionally, they reflect
the pattern of actual defaults in Enterprise data (defaults increase at
a decreasing rate with loan age). OFHEO recognizes that the
significance of the age variables in the multifamily default model may
be substituting for omitted or mismeasured variables. However, there
also is evidence that the aging effect may be a credible discriminator
of default risk in and of itself.\111\ The lack of detailed and
consistently measured operating statement and property condition data
render further investigation of the underlying reasons for the
significance of the age variables on multifamily default risk
difficult.
---------------------------------------------------------------------------
\111\ Edward I. Altman, ``Zeta Analysis and Other Attempts to
Classify and Predict Business Failures,'' Corporate Financial
Distress and Bankruptcy: A Complete Guide to Predicting and Avoiding
Distress and Profiting from Bankruptcy (1993).
---------------------------------------------------------------------------
(iv) Operating Expense Ratio
NPR2 calculated DCR with expenses as a fixed share (47.2 percent)
of the gross potential rents. Fannie Mae commented that a fixed expense
ratio increases the volatility of net operating income and recommended
that OFHEO modify the constant expense factor to reflect the reality
that the components of property level operating expenses are not all
fixed shares of gross income. Fannie Mae suggested that OFHEO reflect
this mixture either by reducing the change in net operating income in
response to a change in vacancy rates or by utilizing actual net
operating income values from the annual operating statements Fannie Mae
receives on multifamily loans.
After consideration of these comments, OFHEO concluded, from both
the literature and the limited availability of data, that neither of
the Fannie Mae approaches should be accepted. OFHEO recognized that
property level operating expenses and its components may not remain
fixed shares of gross rents over time. However, OFHEO is unsatisfied
with current approaches and data available for modeling the inflation
in multifamily property expenses and its components. One study divided
operating expenses into four fixed-share components--labor costs,
utilities, insurance and taxes, and construction materials--and modeled
growth in each with indexes that would reflect the inflation in each
component.\112\ Property-level variances around the mean were also
measured, the author concluding that it would be surprising if
operating expenses varied from one year to the next by amounts as large
as those observed. Other approaches to modeling property level
operating expenses or its components would have required the use of
simplifying assumptions that cannot be tested regarding component
shares of total operating expenses and related indexes approximating
respective growth rates. OFHEO has found insufficient evidence that any
of these methods provided improved estimates over the NPR2 approach.
---------------------------------------------------------------------------
\112\ Jesse M. Abraham, ``On the Use of a Cash Flow Time Series
to Measure Property Performance'' (Working Paper, October 1994).
---------------------------------------------------------------------------
OFHEO also considered Fannie Mae's suggestion to use actual
observations of net operating income from the Enterprises, where
available, to estimate the model. OFHEO found this suggestion
unpersuasive because the percentage of loans with annual DCR in the
estimation dataset was just 14 percent. In terms of observations for
each year in the life of each loan, the percentage of records with
annual DCR dropped to 9.7 percent, with very few of those having three
or more consecutive annual DCR observations (3.7 percent of total loan-
year records). Further complicating the estimation process was the fact
that annual DCRs are not calculated by the Enterprises in the same way
as are origination/acquisition DCRs. While the Enterprises typically
calculate the latter using conservative assumptions of vacancy rates,
rental and other income, expenses, replacement reserves and the like,
the former represent actual data from operating statements, unadjusted
for normal variations from year to year or deviations from market
rates. In sum, the data were too sparse and dissimilar for use in
constructing a reasonably robust model.
Accordingly, in estimating the multifamily default model for the
final rule, OFHEO utilized the NPR2 expense constant for all loan
observations and did not use Enterprise actual net operating income to
update DCR for estimation purposes.
(v) Use of Two Default Models
Both Enterprises commented upon OFHEO's proposal to use two default
models, one for negotiated transactions (NT) and one for cash
purchases. Freddie Mac recommended that the distinction between the two
categories of loans be dropped because it is too difficult to define,
explaining that Freddie Mac was unable to replicate the classification
of its own loans that OFHEO used in NPR2. Fannie Mae echoed these
comments, targeting the NT equation, in particular, as poorly specified
and not a useful guide to multifamily loan performance. No comments
were received supporting the use of two default models. However, both
Enterprises and several other commenters supported the general concept
of distinguishing between multifamily programs or regimes in the stress
test. All commenters on the subject concurred that the underwriting and
servicing practices of the Enterprises underwent major and permanent
changes beginning in 1988 (Fannie Mae) and in 1993 (Freddie Mac), which
should be reflected in the stress test. Comments from seller/servicers
of the Enterprises urged OFHEO to give credit for improvements in
multifamily loan management in order to avoid imposing inappropriately
large marginal capital costs on this portion of the Enterprises'
business. In addition, seller/servicers in Fannie Mae's DUS program
suggested that DUS loans get special treatment to reflect what they
felt were more rigorous guidelines, loss-sharing provisions, and
reserve and reporting requirements in that program.
In considering the need for two default models, OFHEO studied the
changes in the Enterprises' multifamily businesses, analyzed the
comments, and conducted additional modeling research
[[Page 47769]]
with recently provided data that is far more complete than that
previously provided.\113\ OFHEO concluded that the distinction between
NT and cash purchases was no longer sufficiently important to require
two models. Accordingly, OFHEO has replaced the two-model approach with
one multifamily default equation that distinguishes between the
performance of loans with indicator variables that apply a multiplier
to adjust the loans' relative default rates.
---------------------------------------------------------------------------
\113\ The Enterprises recently provided data on 40,247 loans.
Those loans were combined with pre-1991 Fannie Mae data received in
earlier submissions less loans with missing origination dates,
leaving 42,334 loans that were used for analysis. Of the 42,334
loans, 58 percent (24,743 loans, primarily seasoned-at-acquisition
ARMs) had neither origination nor acquisition DCR data. In NPR2, the
missing values were populated by reverse-engineering DCR from the
capitalization rate model and origination/acquisition LTV. In the
final rule, the cap rate model is not used. Instead, five random
samples of the loans with missing origination and acquisition DCR
were taken. Each random sample was combined with the 42 percent of
loans that were not missing origination/acquisition DCR. All samples
produced similar model estimation results; however, the one with the
best goodness of fit was selected as the analysis data set. As in
NPR2, in creating loan-year records from loan-level data, records
prior to the year of Enterprise acquisition were removed to avoid
left-censoring bias. Also, prepayments were right-censored in the
year of loan termination. See C.B. Begg and R. Gray, ``Calculation
of Polychotomous Logistic Regression Parameters Using Individualized
Regressions,'' Biometrica (1984).
---------------------------------------------------------------------------
One of these indicator variables, the New Book Flag (and its
product adjustment factors, the New ARM Flag and the New Balloon Flag),
like the program restructuring variable in NPR2, distinguishes loans
acquired in 1988 and after at Fannie Mae and in 1993 and after at
Freddie Mac (New Book loans) from loans acquired earlier (Old Book
loans). It reflects the fact that during 1988 and 1993, Fannie Mae and
Freddie Mac, respectively, implemented significant permanent changes in
their methods and standards for underwriting and servicing multifamily
loans. Loans acquired after these dates that constitute defensive
refinances of Old Book business remain classified as Old Book. The New
Book Flag has a greater impact on default rates than the NPR2 program
restructuring variable, due to use of additional data in estimating the
model and the decision to eliminate the adjustments to Old Book loan
LTVs and DCRs that are used in NPR2.\114\
---------------------------------------------------------------------------
\114\ The New Book flag is the reciprocal of the program
restructuring variable in NPR2, but it has the same affect. The New
Book Flag decreases the default rate on New Book loans, while the
program restructuring variable increased the default rate on Old
Book loans. The larger impact of the New Book Flag coefficient in
the final rule reflects four additional years of loan performance
that show lower default rates, all else being equal, for New Book
loans in general than were indicated previously. Another reason for
the larger absolute value of the coefficient on New Book loans is
that adjustments to Old Book data were not made in the final rule.
In NPR2, origination/acquisition DCR was adjusted downward and
origination/acquisition LTV was adjusted upward for Old Book loans.
Freddie Mac commented that it was not the case that every Old Book
loan had an overstated DCR and an understated LTV. OFHEO concluded
that the adjustment proposed in NPR2 was not appropriate for every
Old Book loan and that it did not resolve Old Book data integrity
issues. Therefore, the final rule does not use the NPR2 adjustments
to the Old Book loans.
---------------------------------------------------------------------------
In re-evaluating the performance of multifamily New Book versus Old
Book loans, however, OFHEO discovered that the full effect of the New
Book benefit applies only to fixed-rate fully amortizing loans. For
ARMs, the reduction in New Book default risk is significantly less than
for New Book loans in general. Likewise, but to a lesser extent, fixed-
rate balloon loans do not exhibit the full effect of reduced New Book
default risk. These effects are reflected in the multifamily default
model.
The other program indicator variable, the Ratio Update Flag, is
used to identify newly originated loans and seasoned acquisitions on
which DCR and LTV have been updated using conservative measures such as
market-rate minimum vacancy rates, minimum actual historical other
income, forward-looking trended expenses, and minimum replacement
reserves, management fees, and capitalization rates.\115\ After re-
calculation of DCR and LTV, the Enterprises screen these loans for
minimum acceptable DCR and maximum acceptable LTV ratios for purchase
or securitization. OFHEO found that New Book loans that were subjected
to the aforementioned type of ratio update process performed better
than those that were not. Loans with neither origination nor
acquisition DCR are treated as not having undergone the ratio update
process.
---------------------------------------------------------------------------
\115\ The ratio update process may have been performed by the
Enterprise itself or under delegated authority by a qualified
seller/servicer either at loan origination or at Enterprise
acquisition.
---------------------------------------------------------------------------
(vi) Tax Reform and the Depreciation Write-off Variable
No commenters objected directly to the Depreciation Write-off
variable (DW) but, for a number of reasons, OFHEO found it
inappropriate for the multifamily default model in the final rule.
First, the capitalization rate model, which was criticized by
commenters in conjunction with the Joint Probability of Negative Equity
and Negative Cash Flow variable (JP), was also used to construct the
return on equity portion of the weighted average debt and equity
discount rate in the DW variable. Because OFHEO decided to drop the JP
variable from the multifamily default model, largely because of
concerns about the capitalization rate model, it would have been
inappropriate to retain the DW variable. Second, the available data on
value of depreciation write-offs suffered from the same lack of
regional and sub-market variation criticized in the capitalization rate
model.\116\
---------------------------------------------------------------------------
\116\ See Table 34 of NPR2, 64 FR 18203, April 13, 1999
(National values for depreciation write-offs, 1983-1995).
---------------------------------------------------------------------------
(vii) Use of External Benchmarks
Several commenters asked OFHEO to allow external benchmarks and
industry standards to serve as tests of reasonableness for the
multifamily model results until sufficient reliable data become
available to build a more sensitive and detailed model. In most cases,
OFHEO agrees with the commenters that external benchmarks and industry
standards may be used for assessing the reasonableness of multifamily
stress test default rates. For this reason, OFHEO has compared its
simulated stress test results with those provided by the Enterprises in
their comments and consulted rating agency and related analyses.
However, there exist far fewer studies of the determinants of
multifamily default than single family default. Still fewer studies
analyze defaults under stressful economic conditions--and none examines
multifamily defaults through a period of time as stressful as the
stress test. Notwithstanding these limitations, OFHEO found that for
fixed-rate loans both of these avenues provide confirmation that
OFHEO's model results are reasonable.
For multifamily ARM default rates, however, there are no studies
involving stressful economic environments that OFHEO found of adequate
quality and authority to be useful for comparison. For these loans,
OFHEO looked to whether the default rates on the loans appear
reasonable, given their extreme sensitivity to interest rates and
compared the model's results to the limited data that is available
regarding multifamily ARM performance under economic stress. This
analysis confirmed the reasonableness of the ARM model.
These tests of reasonableness employed by OFHEO are discussed
below.
(a) Results Provided by the Enterprises
The Enterprises provided, in their comments, computations of
cumulative multifamily default rates for two
[[Page 47770]]
specific newly originated fixed-rate products--the 15-year fixed-rate
balloon (Fannie Mae) and the ten-year fixed-rate balloon (Freddie
Mac)--as examples of rates that they considered to be reasonable for
managing multifamily risk. Both Enterprises used the NPR2 rent and
vacancy scenario to produce the results and each stated that the
default rates assumed zero prepayments and were for 30-year
amortization loans with eight percent coupons. The respective default
rate tables were divided into cohorts by current DCR immediately prior
to the stress test and origination LTV. Fannie Mae's results were
generated using the NPR2 cash default model. Freddie Mac's results were
generated using a different model that was specified explicitly,
including coefficients (some of which Freddie Mac estimated and others
of which Freddie Mac assumed).\117\
---------------------------------------------------------------------------
\117\ OFHEO tested Freddie Mac's model with the same Enterprise
data used to estimate OFHEO's multifamily default model in the final
rule. OFHEO found poorer overall goodness of fit results than those
achieved with OFHEO's multifamily default model. OFHEO's multifamily
default model in the final rule had a Hosmer-Lemeshow (HL) goodness
of fit statistic of 32.192; (72.0 percent concordant, 24.2 percent
discordant, 3.8 percent tied) compared with an HL statistic of
122.62; (63.3 percent concordant, 28.4 percent discordant, 8.3
percent tied) for Freddie Mac's model. Lower HL statistics indicate
better goodness of fit. See David W. Hosmer, Jr. and Stanley
Limeshon, Applied Logistic Regression (John Wiley & Sons 1990).
---------------------------------------------------------------------------
OFHEO replicated the tables of default rates provided by Fannie Mae
and Freddie Mac, using the multifamily default model in the final rule,
along with the newly constructed rent and vacancy scenario. Under the
same assumptions of zero prepayments, an 8 percent coupon, 30-year
amortization, newly originated product immediately preceding the stress
test, OFHEO obtained results similar to those provided by Fannie Mae
for the 15-year balloon and to those provided by Freddie Mac for the
10-year balloon. For example, for a loan with a 1.20 DCR immediately
prior to the stress test and an 80 percent origination LTV, Fannie Mae
suggested an 18 percent cumulative conditional default rate for the 15-
year balloon and Freddie Mac recommended a 21 percent cumulative
default rate for the 10-year balloon. OFHEO's multifamily default model
in the final rule produced cumulative conditional default rates for the
15-year balloon and for the 10-year balloon of 26 percent and 30
percent, respectively, for the non-ratio-updated products and of 15 and
18 percent, respectively, for those products that underwent the ratio-
update process.
OFHEO believes that the consistency with which its model results
tracked those provided by Fannie Mae and Freddie Mac for the products
and DCR/LTV combinations they supplied helps confirm the reasonableness
of OFHEO's model results. Fannie Mae suggested, however, that their
tabular default rates (or ones like them) be used directly for all
loans with a balloon year multiple of 3.0 at maturity for balloon loans
and that various other indicators of default risk such as product-type,
book of business, and loan age be ignored. OFHEO did not accept this
suggestion, because evidence from various default studies as well as
actual observed default rates of Fannie Mae's own portfolio of
multifamily loans show that default rates do vary significantly by
product type, age, and factors other than current DCR, origination LTV
and balloon maturity risk. OFHEO has captured those other risk factors
while ensuring the reasonableness of model results.
(b) Rating Agency and Related Analyses
Rather than targeting stressful economic conditions, most studies
of the determinants of multifamily default have estimated models over
whatever time period data are available, which may or may not contain a
period of economic stress. As a result, OFHEO turned to the rating
agencies for industry norms with regard to cumulative default rates of
multifamily loans under stress. Each rating agency's methodology for
assessing credit risk is similar to the others', although some focus on
DCR as the primary determinant of default and others on both DCR and
LTV. Though they share their methodologies in print and on the
internet, the rating agencies often do not report subordination levels
for large groups of loans outside of specific security transactions.
Fitch IBCA is the exception.
Fitch IBCA studied 18,839 loans in 33 commercial transactions
issued between 1991 and mid-1996.\118\ The database was composed of two
distinct subgroups, loans from Resolution Trust Corporation (RTC)
transactions and conduit loans,\119\ and a default was defined as a
delinquency of 60 or more days on a mortgage payment or a delinquency
of 90 or more days on a balloon payment. Without regard to CMBS
property type,\120\ Fitch found average annual default rates of 4.37
percent and 1.97 percent, respectively, for RTC and conduit loans.
Fitch described the differential (36 percent versus 18 percent over ten
years, assuming no prepayments) as possibly attributable to qualitative
differences between the pools or the result of other factors such as
seasoning (RTC loans are described as highly seasoned; conduit loans
are described as typically newly-originated at the time of
securitization). The average annual default rate on multifamily
properties was 3.9 percent. This finding translates to a 32.8 percent
cumulative default rate over 10 years, assuming no prepayments.
---------------------------------------------------------------------------
\118\ ``Trends in Commercial Mortgage Default Rates and Loss
Severity--1997 Update,'' Structured Finance (July 20, 1998).
\119\ The term ``conduit loans'' refers to loans, most of which
are newly originated, that are securitized by mortgage conduits,
which generally are brokers.
\120\ The data included loans on commercial property other than
multifamily projects, e.g., shopping centers or office buildings.
---------------------------------------------------------------------------
In another report, Fitch ICBA posts a table of single-A recession
default probabilities by DCR category, adjusted to reflect stressful
economic conditions, but not the mix of collateral and structural
characteristics in the loans.\121\ The default probabilities ranged
from a low of 20 percent (>1.75 DCR) to a high of 80 percent (0.49
DCR), with 40 percent representing the maximum cumulative default
probability for positive (>1.00 DCR) cash flow loans.
---------------------------------------------------------------------------
\121\ ``Performing Loan Securitization Update,'' Structured
Finance (March 16, 2000).
---------------------------------------------------------------------------
A study of the commercial mortgage holdings of the life insurance
industry finds that book value credit losses averaged 76 basis points
per year over the 1972-1996 period, with an annualized volatility of
31 basis points.\122\ Using this study's assumed 30 percent
loss severity rate, ten-year default rates are roughly equivalent to a
maximum of 34 percent.
---------------------------------------------------------------------------
\122\ Michael Giliberto, ``A Performance Benchmark for
Commercial Mortgages,'' Real Estate Finance (Spring, 1997).
---------------------------------------------------------------------------
The studies cited above represent those that OFHEO believes best
represent cumulative multifamily default rates under stressful economic
conditions. Nevertheless, the studies are not entirely comparable to
the stress test because they may not have analyzed loan performance
over a period of time as stressful as the stress test. Additionally,
they either did not address the type of multifamily product analyzed or
stated specifically that only fixed-rate loans were included.
Therefore, the range of cumulative default rates of 30-40 percent would
not be applicable to multifamily ARMs. Further, the studies defined
default more broadly than does the stress test. The stress test defines
default as a foreclosure rather than a 60- or 90-day delinquency. This
discrepancy means that, all else equal, the 30-40 percent default rate
range found in the studies would be lower if OFHEO's narrower default
definition were used. Because
[[Page 47771]]
the rating agency and related studies, to varying degrees, include
products of various levels of seasoning and quality, the range of
results may be interpreted as a weighted average of default rates for a
diversified portfolio of multifamily loans.
Taking the above factors into consideration, OFHEO found the rating
agency findings are consistent with the results of OFHEO's multifamily
default model in the final rule. Assuming zero prepayments, OFHEO finds
a cumulative conditional default rate of 39 percent for a typical
Enterprise fixed-rate loan.\123\ Further, OFHEO finds that it is
reasonable and appropriate to allow default rates in the stress test to
vary with product type, product quality, and loan age. As a result,
OFHEO has determined that the default rates derived directly from the
application of the multifamily default model in the final rule to
Enterprise fixed-rate loans will be used, without further adjustment or
calibration.
---------------------------------------------------------------------------
\123\ Using Enterprise data, OFHEO defined the typical
Enterprise multifamily loan as a ten-year fixed-rate balloon loan,
with an origination LTV of 80 percent and a current DCR at the start
of the stress test of 1.20. Roughly 86 percent of Enterprise fixed-
rate loans are from the New Book and 65 percent of fixed-rate loans
qualify for the Ratio Update Flag. The mean age of fixed-rate loans
at the start of the stress test is 48 months. The current DCR and
origination LTV ranges represent the highest frequency distribution
category for Enterprise fixed-rate loans. OFHEO produced the default
rates using those ranges along with the mean loan age and share of
New Book and Ratio Update loans (in lieu of 1 and 0 for those
flags). In practice, those flags would either be 1 or 0.
---------------------------------------------------------------------------
(c) Multifamily ARM Analysis
The Enterprises did not provide default rates considered reasonable
for managing multifamily ARM business, and OFHEO found no comparable
rating agency or related analyses specifically addressing ARM default
rates in stressful economic environments. However, OFHEO also did not
model multifamily default rates separately for fixed-rate and ARM
product in the final rule. The default models are identical. In their
implementation, ARM loans default at higher rates than fixed-rate
loans, all else equal, even if interest rates are held stable.\124\
However, when interest rates ramp up (plummet) in the first year of the
up-rate (down-rate) stress test, ARM loans experience payment shock
(reductions), pushing current DCR lower (higher) at any level of NOI.
In sharp contrast, fixed-rate loans, which by definition have constant
payments, exhibit changes in current DCR that are driven only by
changes in NOI. OFHEO finds that this is perfectly consistent with the
stress test interest-rate environment mandated in the 1992 Act.
---------------------------------------------------------------------------
\124\ The New ARM Flag retracts much of the reduction in default
risk that the New Book Flag conveys.
---------------------------------------------------------------------------
Assuming no prepayments, OFHEO finds a cumulative conditional
default rate for a typical Enterprise ARM loan of 29 percent in the
down-rate scenario and 97 percent in the up-rate scenario.\125\ OFHEO
found that ARM down-rate default rates are consistent with fixed-rate
default rates, which are in turn consistent with data provided by the
Enterprises and with rating agency analyses.
---------------------------------------------------------------------------
\125\ Using Enterprise data, OFHEO defined the typical
Enterprise multifamily ARM loan as one indexed to the 11th District
Cost of Funds, with periodic rate caps and floors of two percent,
annual payment caps of 7 percent and a 1.25 negative amortization
limit, an origination LTV of 80 percent and a current DCR at the
start of the stress test of 1.20. Roughly 50 percent of Enterprise
ARM loans are from the New Book and 3 percent of ARM loans qualify
for the ratio update treatment. The mean age of ARM loans at the
start of the stress test is 91 months. The current DCR and
origination LTV ranges represent the highest frequency distribution
category for Enterprise ARM loans. OFHEO produced the default rates
using those ranges along with the mean loan age and share of New
Book and Ratio Update loans (in lieu of 1 and 0 for those flags).
---------------------------------------------------------------------------
OFHEO also believes that the range of ARM up-rate default rates is
not unreasonable given the experience of certain multifamily loans
historically. OFHEO tested for the highest level of defaults observed
for Federal Housing Administration (FHA) and Enterprise multifamily
loans originated in 1979-1992 in contiguous states comprising five
percent or more of the U.S. population for a period of two or more
consecutive years. The worst weighted average default experience found
in the FHA data was for 12 loans originated in 1987-88 in New England
(CT, MA, ME, NH, RI, and VT) at 78 percent. The worst default
experience for Enterprise multifamily loans--fixed-rate (289 state-year
combinations), ARM (six state-year combinations) and combined (two
state-year combinations)--was 100 percent. The third-highest level of
Enterprise multifamily default experience was for six loans originated
in 1979-80 (AR, CO, LA, MT, OK and WY) at 87 percent while the seventh-
highest level of ARM default experience for the Enterprises was for six
loans originated in 1984-86 (CT, MA, ME, NH, RI, VT) at 91 percent.
OFHEO found these statistics useful in that they substantiate the fact
that default rates of the magnitude found in the up-rate scenario for
multifamily ARMs have indeed occurred and would be likely to recur in
an economic environment such as the stress test. As a result, OFHEO has
determined that the default rates derived directly from the application
of the multifamily default model in the final rule to Enterprise ARM
loans will be used, without further adjustment or calibration.
b. Multifamily Prepayment Model
The proposed rule used the following variables to determine
prepayment rates for multifamily loans:
Mortgage Age Variables--Used to capture change in the risk
of prepayment as loans age.
Relative Spread--Used to reflect the value to the borrower
of the option to prepay and refinance.
Current LTV--Used to capture the incentive for borrowers
to refinance in order to withdraw equity from rental property.
Probability of Qualifying for Refinance--Used to reflect
the likelihood that a property financed by a balloon loan would qualify
for a new loan, based on minimum requirements of 80 percent LTV or less
and 1.20 DCR or more.
Pre-balloon Refinance Incentive--Used to give extra weight
to the relative spread in the two years prior to the balloon maturity
to capture additional incentive to prepay balloon loans after the date
the yield maintenance period ends, but before the balloon maturity
date.
Conventional Market Rate for Mortgages--Used to reflect
the incentives for borrowers with ARMs to refinance into fixed-rate
mortgages.
Years-To-Go in the Yield-Maintenance Period--Used to
capture the declining cost of yield maintenance to the borrower in the
later years of the yield-maintenance period.
(i) Comments
Many comments addressed the proposed multifamily prepayment models.
None were supportive of the proposed approach. Several of these
comments suggested that the data are too limited to support the five
separate models used in NPR2. The Enterprises and others expressed a
view that the proposed rule incorporated incorrect assumptions about
the cost to the borrower (and, therefore, about prepayment of loans)
throughout the yield-maintenance or prepayment penalty period.
Commenters also argued that the prepayment models were overly complex
in the number of variables and the treatment of those variables. Most
of these commenters contended that only a small percentage of loans
prepay during the yield maintenance or prepayment penalty periods and,
of those that do, virtually all are required to pay yield maintenance
fees or prepayment penalties, which are designed to
[[Page 47772]]
compensate an Enterprise for loss of interest income. These comments
suggested that, by not taking prepayment provisions properly into
account, the stress test overstated prepayments, particularly in the
down-rate scenario. The Enterprises both recommended that the final
rule eliminate much of the complexity of the proposal in favor of using
fixed prepayment percentages per month. Freddie Mac recommended zero
percent in the up-rate scenario and, in the down-rate scenario, zero
percent within yield maintenance or other prepayment penalty periods
and 25 percent per year outside such periods. Fannie Mae recommended a
similar approach, suggesting prepayments in the up-rate scenario of
0.02 percent per month and, in the down-rate scenario, 0.2 percent per
month within prepayment penalty periods and two percent per month
outside those periods.
(ii) OFHEO Response
OFHEO has considered the comments, studied the operation of the
yield maintenance provisions in Enterprise multifamily loans agreements
and reviewed the literature regarding multifamily prepayments. Given
the limitations of Enterprise data, OFHEO has concluded that a
prepayment model would not provide greater precision or risk
sensitivity than a fixed schedule of prepayments in the two interest
rate scenarios. OFHEO has also determined that the yield maintenance
and other prepayment penalty provisions in Enterprise multifamily loans
are sufficient either to discourage prepayments during prepayment
penalty or yield maintenance periods or to ensure that the Enterprises
are entitled to the specified compensation. However, modeling these
various prepayment provisions would add additional complexity to the
model, which OFHEO finds unwarranted given the small number of times
yield maintenance or prepayment penalties are required to be paid.
OFHEO agrees with Freddie Mac with regard to the lack of
multifamily prepayments in the up-rate scenario. Fannie Mae suggested
there should be only negligible prepayments (0.02 percent per month) in
the up-rate scenario. OFHEO recognizes that it is not cost effective
for multifamily borrowers to prepay their mortgages at positive spreads
of the market interest rate from the note rate and, as a result, they
are highly unlikely to do so, particularly when yield maintenance or
other prepayment penalties are involved. As a result, OFHEO will use
zero prepayments in the up-rate scenario for multifamily loans.
OFHEO disagrees with Freddie Mac's recommendation of zero
prepayments in the down-rate scenario inside prepayment penalty
periods. Freddie Mac's recommendation of zero prepayments in the up-
rate scenario (both inside and outside prepayment penalty periods) and
in the down-rate scenario inside prepayment penalty periods suggests
that Freddie Mac believes that Enterprise loans never prepay within
yield maintenance or prepayment penalty periods. OFHEO recognizes that
yield maintenance and other types of prepayment penalty provisions are
effective deterrents to multifamily prepayments, as they raise
(sometimes significantly) transactions costs, thereby requiring a
larger drop in interest rates, all else equal, to trigger a prepayment
decision. However, one study contends that prepayments do occur during
yield maintenance and other prepayment penalty periods and should be
priced for.\126\ This study examined five different types of prepayment
penalty structures finding that yield maintenance is the most effective
type of the prepayment penalty structures studied. Also, Enterprise
data provided to OFHEO for analysis show that just over seven percent
of loans that prepaid had prepaid within their prepayment penalty
periods.\127\ Since Enterprise data are not sufficiently detailed to
delineate different prepayment structures at this time, it is likely
that the observed prepayments may be more related to one type of
structure than to another or to the length of time remaining before the
expiration of the penalty altogether. OFHEO also would expect the
number of prepayments to be larger regardless of the prepayment penalty
structure if the loan interest rate, taking into account prepayment
penalty fees, was strongly in the money, as it would be in the down-
rate scenario. As a result, OFHEO has specified 2 percent per year
prepayments inside yield maintenance and other prepayment penalty
periods during the down-rate scenario. This percentage allows
marginally fewer prepayments than recommended by Fannie Mae (0.2
percent per month or 2.37 percent per year) due to the fact that OFHEO
is not modeling the fee income generated by the limited number of
prepayments inside prepayment penalty periods in the down-rate
scenario.
---------------------------------------------------------------------------
\126\ Qiang Fu, Michael LaCour-Little and Kerry Vandell,
``Multifamily Prepayment Behavior and Prepayment Penalty Structure''
(Working Paper, December 21, 1999).
\127\ According to Enterprise data through 1999 submitted to
OFHEO for analysis, 15 percent of Enterprise multifamily loans have
yield maintenance or other prepayment penalty provisions. Of those,
9 percent (660 loans) terminated in or before 1999--the last
recorded year of data. Of those that terminated, 113 loans had
prepaid through 1999. Of those, 8 loans (7.1 percent) prepaid within
their prepayment penalty periods and 105 loans (93 percent) prepaid
outside their prepayment penalty periods. The remaining 547 were
loans that had not prepaid as of the end of 1999.
---------------------------------------------------------------------------
OFHEO generally agrees with Freddie Mac's and Fannie Mae's
respective recommendations of 25 percent per year and 2 percent per
month (21.5 percent per year) prepayments outside of yield maintenance
and prepayment penalty periods in the down-rate scenario. One study
found that the most important determinant of multifamily prepayment was
the ratio of the mortgage note rate to the current market interest
rate.\128\ Using coefficients provided in the study and assuming a
newly originated loan (because parameter estimates for the age function
were not provided), OFHEO found a 29 percent per year prepayment rate
for multifamily loans outside of yield maintenance and other prepayment
penalty periods, confirming the reasonableness of Fannie Mae's and
Freddie Mac's estimates. Additionally, in the Enterprise data, OFHEO
found extreme differences in multifamily prepayments during and after
prepayment penalty periods. This observation is supported by a study
that finds that prepayments are typically close to zero within
prepayment penalty periods, then spike up in a ``hockey stick'' fashion
as soon as the prepayment penalty period expires.\129\ Further, another
study found that, in general, multifamily and other commercial
borrowers are more ``ruthless'' or have greater interest rate
sensitivity than, for example, single family borrowers, making them
more likely to prepay at any given level of negative spread between
market rates and note rates, particularly when transactions costs such
as prepayment penalties are not at issue.\130\ For these reasons, OFHEO
has decided to specify 25 percent prepayments per year outside yield
maintenance and other prepayment penalty periods in the down-rate
scenario. This specification is consistent with the mid-point of the 21
percent to 29 percent range provided by
[[Page 47773]]
Freddie Mac, Fannie Mae and in the literature.
---------------------------------------------------------------------------
\128\ Qiang Fu, et al., supra n. 126.
\129\ Jesse M. Abraham and Scott Theobald, ``A Simple Prepayment
Model of Commercial Mortgages,'' Journal of Housing Economics
(1995).
\130\ James R. Follain, Jan Ondrich, and Gyan Sinha, ``Ruthless
Prepayment: Evidence from Multifamily Mortgages,'' 41 Journal of
Urban Economics (1997).
---------------------------------------------------------------------------
c. Multifamily Loss Severity Calculation
To determine loss severity rates on all conventional multifamily
loans, other than NT loans covered by repurchase agreements, NPR2 used
the same cost and revenue elements and discounting procedures used for
conventional single family loans, except that property values were not
updated to determine the loss of loan principal balance. The cost and
revenue components were averages from Freddie Mac real estate owned
(REO) originated in the 1980s. Loss severity rates on NT loans subject
to repurchase agreements were set at a fixed rate based upon Enterprise
historical experience and seller/servicer claim rates for 90-day
delinquent multifamily loans. For FHA loans, the severity rate was set
at three percent of UPB to reflect the cost of assigning defaulted
loans to the Department of Housing and Urban Development.
Several comments addressed the loss severity calculations proposed
in NPR2.\131\ In general, commenters did not object to the methodology
employed by OFHEO. They did, however, suggest that the loss severity
rates arrived at with this approach were higher than industry averages
and recommended that OFHEO simply apply a uniform severity rate to all
multifamily loans. At a minimum, commenters recommended that OFHEO
assess loss severity rates against industry standards as guidelines for
reasonableness, as they had similarly suggested for multifamily default
rates. Specifically, Fannie Mae and Freddie Mac commented that the data
available to OFHEO, primarily Freddie Mac Old Book loans, were an
inappropriate sample to estimate multifamily loss severity. Because of
changes in the Enterprises' current loan programs, they contended, the
severity rates to be expected on newer loans would be significantly
lower than reflected in the data.
---------------------------------------------------------------------------
\131\ NPR2 actually proposed six severity treatments: (1)
retained cash loans without recourse, (2) sold cash loans without
recourse and NT loans without repurchase, (3) retained cash loans
with recourse, (4) sold cash loans with recourse, (5) NT loans with
repurchase, and (6) FHA loans. The NT distinction has been
eliminated in the final rule, as discussed above at III.I.3.a.i.,
Negative Equity and Current LTV Variables and no comments were
received about the three percent severity rate imposed upon FHA
loans. For these reasons, references to the NPR2 approach are to the
first four treatments, unless otherwise indicated.
---------------------------------------------------------------------------
OFHEO rejected the suggestion that a uniform severity rate be
applied to each multifamily loan in each period of both the up- and
down-rate scenarios. Throughout the stress test, rental vacancy rates
increase to a peak of 17.5 percent and rent growth is negative for over
twenty consecutive months. In an economic situation replicating the
ALMO benchmark region and time period, the revenue and cost components
of multifamily REO while in inventory, as well as recovery rates on REO
sales, would not remain fixed. Studies have shown that multifamily
property values fall significantly during regional economic recessions,
leading to lower recovery rates on REO.\132\ Likewise, rental income
would decline as vacancy rates rise. Further, some costs incurred
during the REO holding period, such as attorney's fees, would likely
remain fixed while others, such as property operating expenses, may
shrink as tenants vacate; they may also remain the same or increase as
landlords attempt to attract new tenants to replace those that have
vacated. OFHEO concluded that fixed loss severity rates for Enterprise
multifamily REO would not reflect the requirement that severity rates
in the stress test be reasonably related to the conditions of the
benchmark loss experience.
---------------------------------------------------------------------------
\132\ ``Commercial Mortgage Stress Test Research,'' Structured
Finance (October 23, 1998); ``Trends in Commercial Mortgage Default
Rates and Loss Severity--1997 Update,'' Structured Finance (July 20,
1998).
---------------------------------------------------------------------------
OFHEO also concluded that updating the NPR2 methodology with
additional data from the Enterprises would not be consistent with the
1992 Act. Given the requirements of the 1992 Act that the stress test
must reflect a worst-case loss experience, single family loss severity
rates are calculated using cost components, where available, for the
ALMO benchmark loans. It would, therefore, be inappropriate to update
the multifamily loss severity components simply because newer data from
better economic scenarios reflect lower losses. In contrast, OFHEO
found it appropriate to update the data used to estimate the
multifamily default model, because the model imposes benchmark
conditions through the use of ALMO benchmark rent growth and vacancy
rates.
OFHEO has determined to use the revenue and cost components of
multifamily loss severity as well as the REO recovery rates as
published in NPR2, as they represent worst-case Enterprise losses.\133\
A simple adding up of the costs components of those figures (without
considering discounting, credit enhancements or passthrough interest on
sold loans), yields a loss severity rate of 54 percent. OFHEO did, in
fact, find higher loss severity rates. Fitch IBCA found loss severity
rates ranging from 32 percent to 58 percent on bulk sales of RTC
assets. Additionally, and in that same report, Fitch explains that
Freddie Mac reports that, if a default occurs, on average 45 percent of
the loan balance is lost. Actual Freddie Mac loss severities, however,
ranged from 8 percent in the Northeast to 52 percent in Alaska.
Finally, in describing Fannie Mae's 70-75 percent recovery rates on
multifamily REO, Fitch concludes that their historical loss information
did not include recoveries during adverse market conditions.\134\
---------------------------------------------------------------------------
\133\ For simplicity, foreclosure costs and operating losses are
added together as net REO holdings costs.
\134\ ``Commercial Mortgage Stress Test Research,'' supra, note
132.
---------------------------------------------------------------------------
OFHEO has simplified the loss severity calculation in the final
rule. The six separate loss severity calculations proposed in NPR2 are
replaced by one loss severity equation, which eliminates the redundancy
in the first four equations. Those equations differed only in that one
of them accounted for passthrough interest on sold loans and one did
not. Similarly, one of them accounted for loss-sharing receipts on
loans covered by loss-sharing agreements and one did not. Passthrough
interest on sold loans and loss-sharing receipts remains part of the
loss severity calculation. However, the final rule simply calculates
four months of passthrough interest on sold, but not on retained loans,
and loss-sharing receipts, if applicable, are included with other forms
of credit enhancements.
In addition, the separate methodology used in NPR2 for arriving at
loss severity for NT loans with repurchase agreements has been
eliminated in the final rule. OFHEO determined that the NPR2 loss
severity of 39 percent for these loans, arrived at by multiplying a 70
percent historical foreclosure rate by 56 percent (the share of Freddie
Mac's 90-day delinquencies that end in foreclosure or other costly loan
resolutions), is no longer applicable. OFHEO determined that the
correct place to account for the potential cure rate of 90-day
delinquent loans (as opposed to those that ultimately would end in
foreclosure), is in the multifamily default model, rather than in the
loss severity calculation. Appropriately, OFHEO included a correction
there.\135\
---------------------------------------------------------------------------
\135\ In multifamily default modeling, the default event for NT
loans repurchased by seller/servicers must be a 90-day delinquency,
as OFHEO was not supplied with information regarding the final
resolution of these loans. OFHEO adjusted for the broader definition
of defult for NT loans (90-day delinquency) relative to the one used
for all other multifamily loans (foreclosure) by undersampling NT
defaults for inclusion in the historical estimation data set prior
to model estimation. A stratified random sample of loans missing
both origination and acquisition DCR was taken for inclusion in the
estimation data set. Those loans sampled were overwhelmingly NT (68
percent), seasoned-at-acquisition (64 percent), and ARMs (63
percent). By contrast, loans with either origination or acquisition
DCR were overwhelmingly non-NT (90 percent), newly-originated at
Enterprise acquisition (80 percent), and fixed-rate mortgages (95
percent). A 10 percent stratified random sample of loans missing
both origination/acquisition DCR yielded 2,498 loans (157 defaults
and 2,303 non-defaults). The default sample wsa reduced to 126 loans
based upon an estimated cure rate of 30 percent for the portion of
the loans missing both origination and acquisition DCR that were NT.
---------------------------------------------------------------------------
[[Page 47774]]
For FHA loans, the final rule retains the severity rate of three
percent of UPB that was proposed in NPR2 to reflect the cost of
assigning defaulted loans to the Department of Housing and Urban
Development.
J. Other Credit Factors
To reflect counterparty or security defaults during the stress
period, NPR2 proposed to reduce the payments from each counterparty or
security to the Enterprises by an amount, or ``haircut,'' determined by
the public credit rating of the counterparty or security. These
haircuts were phased in linearly over the 120-month stress period
beginning in the first month. OFHEO received a considerable number of
comments on the level, timing, and calculation of the haircuts, which
are discussed below by topic.
1. Haircut Levels for NonDerivative Counterparties and Securities
For all securities and counterparties except derivative contract
counterparties, NPR2 proposed ten-year cumulative haircuts of ten
percent for counterparties and securities rated triple-A, 20 percent
for double-A, 40 percent for single-A, and 80 percent for triple-B and
below and for unrated counterparties or securities. These haircuts were
based on a consideration of Moody's 1998 study of corporate bond
defaults, Standard and Poor's (S&P) approach to rating structured
mortgage securities, and Duff & Phelps' (D&P) approach to evaluating
credit supports provided by mortgage insurance companies. \136\
---------------------------------------------------------------------------
\136\ ``Historical Default Rates of Corporate Bond Issuers,
1920-1997,'' Moody's Investors Service, February 1998; S&P's
Structured Finance Criteria,'' Standard & Poor's Corporation, 1988;
and ``Evaluation of Mortgage Insurance Companies,'' Duff & Phelps,
November, 1994. The Moody's study, which showed cumulative default
rates over various time horizons for each rating category, suggests
that the ten-year cumulative default rate roughly doubles for each
one-level drop in rating category. In rating structured mortgage
securities, S&P discounts the claims-paying ability of mortgage
insurers in a double-A stress environment by 20 percent for double-
A-minus-rated mortgage insurers, and 60 percent for single-A-rated
insurers. In rating mortgage insurers in a triple-A stress
environment, D&P discounts double-A rated reinsurers by 35 percent,
single-A-rated reinsurers by 70 percent, and triple-B-rated
reinsurers by 100 percent.
---------------------------------------------------------------------------
a. Comments
A number of commenters, including the Enterprises and several Wall
Street firms, disagreed with OFHEO's methodology, asserting that the
resulting haircuts were too severe and not representative of historical
experience. In particular, they suggested that OFHEO's proposed
haircuts were greater than those that would be implied by the Great
Depression, citing the 1958 study of corporate bonds by W. Braddock
Hickman.\137\ These commenters concluded that the default rates implied
by OFHEO's haircuts were too high.
---------------------------------------------------------------------------
\137\ W. Braddock Hickman, Corporate Bond Quality and Investor
Experience, National Bureau of Economic Research (1958).
---------------------------------------------------------------------------
Freddie Mac questioned the appropriateness of basing stress test
haircuts on S&P's approach, because S&P uses it to evaluate structured
finance securities. Structured finance transactions, Freddie Mac
asserted, require credit support levels to cover risks not faced by the
Enterprises because in such transactions there is little ongoing risk
management capability, no diversification across pools, and no ability
to retain earnings. Instead, Freddie Mac recommended basing the
haircuts on both default and recovery rates. It suggested developing
default rates by 1) comparing mortgage default rates associated with
the benchmark loss experience to average mortgage default rates,
stating that the former are roughly three times higher than the latter,
and 2) applying this multiple to Moody's average ten-year cumulative
corporate bond default rates since 1970. Freddie Mac provided an
analysis supporting cumulative haircuts of 1.2 percent for triple-A,
1.5 percent for double-A, 2.3 percent for single-A, and 6.6 percent for
triple-B and below and unrated, and recommended that these haircuts be
adjusted downward by at least 30 percent in the up-rate scenario, to
reflect general price inflation. Freddie Mac suggested that OFHEO
assume a 50 percent recovery rate for defaulting mortgage insurers,
citing the liquidation of a mortgage insurance company in the 1980's,
and a 50 percent liquidation value for defaulting securities, citing
Hickman and Moody's. The Moody's study used defaulting bond prices as
the basis for evaluating recoveries; the Hickman study evaluated actual
recoveries for bond defaults resolved before 1944, and January 1, 1944,
prices for bonds trading below their amortized book value at that time.
Fannie Mae objected to OFHEO's reliance on rating agency approaches
because it believes they are inconsistent with the data in the post-
1970 period and not reasonably related to the benchmark loss
experience. Based on its own analysis, Fannie Mae recommended default-
based haircuts of three percent for triple-A, four percent for double-
A, eight percent for single-A, and twelve percent for triple-B and
below and unrated, and suggested that first-year defaults should not
exceed 0.50 percent for triple-A-rated and 1.0 percent for double-A and
single-A rated credits. Citing Hickman and Moody's, Fannie Mae
described its suggested default rates as ``very conservative and
substantially in excess of bond default performance over the benchmark
time period'' Fannie Mae further suggested that these haircuts be
reduced by an assumed liquidation value of 50 percent for securities,
to account for recoveries, and by insurance premiums and servicing
fees, to offset losses on insurer and recourse counterparty defaults.
Another commenter pointed out that servicing fees under Fannie Mae's
multifamily DUS program include a substantial risk premium.
In general, GE Capital supported OFHEO's haircut proposal except
for the treatment of interest rate and currency derivative contract
counterparties, which is discussed below under III.J.2., Derivative
Contract Counterparties. In its reply comments, GE Capital pointed out
that OFHEO's haircuts are consistent with rating agency discounts of
reinsurance benefits, but noted that by imposing them over time,
OFHEO's haircuts are far less than those discounts. MICA also supported
OFHEO's haircuts but argued that triple-A and double-A mortgage
insurers should be treated more favorably than other counterparties,
with no distinctions between triple-A and double-A rated mortgage
insurers. (See section III.J.5., Mortgage Insurer Distinctions below.)
In their reply comments, GE Capital and MICA criticized the way the
Enterprises used the Hickman and Moody's studies to suggest lower
haircut levels. They noted that the Enterprises included data from the
Hickman study on defaults only for large issues, which are generally
substantially lower than for smaller issues of the same rating, and
that the Enterprises had insufficient basis for their extrapolation of
ten-year default rates from quadrennial data. They also questioned the
Enterprises' exclusion of earlier corporate default experience in their
reliance on Moody's average default rates since 1970. GE Capital
[[Page 47775]]
pointed out that using an average observation plus three standard
deviations would be a more statistically valid method of establishing
stress test default rates than using a multiple of three, and would
result in default levels significantly higher than those suggested by
the Enterprises but lower than those reflected in the haircuts proposed
by NPR2.
Neither GE Capital or MICA favored reflecting recoveries, primarily
because they regard the Enterprises' assumptions as questionable and
unsupported by authoritative data.\138\ Both disagreed that defaulted
bond prices serve as a proxy for recovery rates on mortgage credit
enhancements and questioned whether mortgage insurance premiums
(especially if paid up front) or servicing rights would offset losses
on mortgage credit enhancements to any significant extent.
---------------------------------------------------------------------------
\138\ However, MICA supported lower haircuts for triple-A- and
double-A-rated mortgage insurance companies relative to any other
counterparties, regardless of rating, as discussed below under
``Rating Categories.''
---------------------------------------------------------------------------
World Savings asserted that the haircut differentials between
triple-A, double-A and single-A ratings in NPR2 were too great, citing
Moody's and S&P's rating definitions. It proposed haircuts for these
ratings of five percent, ten percent, and fifteen percent,
respectively, with significantly larger haircuts applied to lower-rated
institutions, particularly those with non-investment grade ratings.
b. OFHEO's Response
In NPR2, OFHEO pointed out certain conceptual similarities between
its approach to discounting for counterparty risk and those of the
rating agencies, but did not rely on rating agency methodologies for
default levels. For example, OFHEO's use of haircuts to reflect losses
due to counterparty failure is similar to the methodology of Moody's,
S&P and D&P.\139\ OFHEO's approach is also similar to that of S&P and
D&P in that in the proposed stress test, failing counterparties meet
some but not all of their obligations (i.e., over time, haircuts
increase to a maximum level), rather than meeting all of their
obligations until the counterparty fails (i.e., haircuts are constant
over time). OFHEO also observed that Moody's 1998 bond study revealed
that default rates roughly double for each drop in ratings and employed
a similar relationship in defining haircuts for the various rating
categories. OFHEO does not believe that consideration of these concepts
is inappropriate for the purposes of the stress test, regardless of the
purpose for which the rating agency methodologies were developed. With
respect to default levels, OFHEO noted in NPR2 that the default levels
reflected in maximum haircuts included in NPR2 are higher than recent
experience and, according to Moody's 1998 study, six to ten times the
average ten-year cumulative default levels from 1920 through 1997.
---------------------------------------------------------------------------
\139\ On June 1, 2000, D&P merged with Fitch ICBA. The merged
company is called ``Fitch.''
---------------------------------------------------------------------------
In the course of evaluating the recommendations for lower haircuts,
OFHEO reviewed Moody's 2000 bond study,\140\ as well as the Hickman
study. According to Hickman, the worst four-year cumulative default
rates for investment grade corporate securities were 6.2 percent (1932-
35) and 7.0 percent (1912-15).\141\ In order to compare these rates
with the historical average, OFHEO extrapolated ten-year rates
consistent with these four-year rates, which were 21.0 and 23.7
percent, respectively.\142\ These rates are 4.3 and 4.9 times greater
than the historical average ten-year rate for the period from 1920-1999
of 4.85 percent from the Moody's study. As shown in Table 5 below, the
default levels the Enterprises proposed as a basis for stress test
haircuts (which they recommended be reduced by 50% to account for
recoveries) reflect significantly lower multiples of Moody's average
historical 10-year cumulative default rates than the extrapolated ten-
year default rates that occurred during the most stressful periods
identified by Hickman. Based on this analysis, OFHEO concluded that
while the default rates reflected in the haircuts included in NPR2 were
high, the default rates proposed by the Enterprises are too low.
---------------------------------------------------------------------------
\140\ ``Historical Default Rates of Corporate Bond Issuers,
1920-1999,'' Moody's Investors Service, January 2000.
\141\ Hickman, at 189.
\142\ These rates were extrapolated by multiplying Hickman's 4-
year cumulative default rates from 1932-1935 and 1912-1915 by the
ratio of Moody's historical average 10-year rate from 1920-1999 of
4.85 percent to Moody's historical average 4-year rate of 1.43
percent. (Moody's, at 27.)
Table 5.--Comparison of Historical 10-Year Cumulative Default Rates With Those Recommended by the Enterprises as
a Basis for Stress Test Haircuts
----------------------------------------------------------------------------------------------------------------
(B) Freddie (C) Fannie
(A) Moody's Mac's Recom- Mae's Recom-
Rating Average Rates mended (B)/(A) mended (C)/(A)
1920-1999 \1\ Haircuts Haircuts
----------------------------------------------------------------------------------------------------------------
AAA 1.09% 2.3% 2.1 x 3.0% 2.8 x
----------------------------------------------------------------------------------------------------------------
AA 3.10% 2.9% 1.1 x 4.0% 1.3 x
----------------------------------------------------------------------------------------------------------------
A 3.61% 4.7% 1.3 x 8.0% 2.2 x
----------------------------------------------------------------------------------------------------------------
BBB 7.92% 13.2% 1.7 x 12.0% 1.5 x
----------------------------------------------------------------------------------------------------------------
\1\ ``Historical Default Rates of Corporate Bond Issuers, 1920-1999,'' Moody's Investors Service, January 2000,
at 27.
With respect to the relationships among cumulative default rates
for credits in different rating categories, the Moody's data for 1920-
1999, as reflected in the table, show cumulative defaults roughly
tripling between the triple-A and double-A categories, increasing by
15% from double-A to single-A, and then doubling from single-A to
triple-B, rather than doubling in every case.
Haircuts included in the final rule reflect consideration of the
relationship between cumulative default rates in normal and stressful
times, the ameliorating effect of phasing in haircuts over time, mixed
commenter opinion with respect to recoveries, the potential for
insurance premiums or servicing fees to partially offset losses on
mortgage credit enhancements, as well as the relationships among
cumulative default rates for credits in different rating categories.
OFHEO
[[Page 47776]]
determined that the haircuts proposed in NPR2 should be reduced and
phased in more quickly. In the final rule, maximum haircuts for
securities and counterparties other than derivative contract
counterparties are lowered from 10 to 5 percent for those rated triple-
A, from 20 to 15% for double-A, from 40 to 20 percent for single-A, and
from 80 to 40 percent for triple-B. They are phased in linearly over
the first five years of the stress period and remain constant
thereafter.
2. Derivative Contract Counterparties
In recognition of the routine use of collateral pledge agreements
with interest rate and foreign-currency derivative contracts, NPR2
proposed haircuts for derivative contract counterparties\143\ that are
lower than haircuts for other counterparties. Collateral posted under
these agreements is continuously re-evaluated, which limits an
Enterprise's risk exposure. For counterparties to interest rate
contracts and foreign currency derivative contracts that fully hedge
their corresponding exchange rate exposure, NPR2 proposed ten-year
cumulative haircuts of two percent for triple-A-rated counterparties,
four percent for double-A-rated counterparties, eight percent for
single-A-rated counterparties, and 16 percent for counterparties rated
triple-B and below and unrated counterparties. In the case of
derivative contracts that fully hedge the foreign exchange risk of
foreign-currency-denominated debt, NPR2 proposed that the stress test
increase the amount in dollars owed by an Enterprise by the derivative
haircut percentage. (See section III.J.4., Foreign Exchange Risk) below
for a discussion of the treatment of any unhedged foreign exchange
risk.)
---------------------------------------------------------------------------
\143\ For the purposes of the risk-based capital regulation, the
term ``derivative contract'' refers only to interest rate, foreign
currency, and similar derivative contracts for which values are
easily determined; i.e., which can easily be marked to market. It
does not include derivative securities or credit derivative
contracts, for which markets are not sufficiently developed to
facilitate accurate market valuations. (See III.K., Mortgage Credit
Enhancements, for a fuller discussion of credit derivatives.)
---------------------------------------------------------------------------
a. Comments
Freddie Mac and Morgan Stanley suggested eliminating the haircuts
for derivative contracts entirely, stating that counterparty risk for
derivative contracts would more properly be characterized as management
and operations risk, and should therefore be subsumed in the 30 percent
management and operations risk add-on. Fannie Mae and Freddie Mac
proposed, alternatively, that OFHEO apply minimum capital treatment to
derivative contract exposure rather than attempting to model cash
flows. On the other hand, a number of commenters supported applying the
proposed haircuts for mortgage credit enhancement counterparties to
interest rate and foreign currency derivative contract counterparties.
GE Capital was among these commenters, but favored applying NPR2's
haircut for triple-A derivative contract counterparties to contracts
collateralized by cash or Treasury securities as of the start of the
stress test, to the extent of such collateral coverage.
b. OFHEO's Response
OFHEO rejects the idea that derivative contract counterparty
exposure constitutes a management or operations risk, since the
magnitude of these exposures, even as mitigated by collateral pledge
agreements, is driven by interest rate, credit, and foreign currency
risk factors. OFHEO disagrees that minimum capital treatment is
appropriate for derivative contract counterparty exposure for two
reasons. First, for interest rate derivative contracts, exposure and
related collateral requirements likely will vary dramatically between
the up- and down-rate scenarios. A simple leverage ratio would not
capture such fluctuations. Second, the amount of collateral pledged at
the start of the stress test, an important determinant of the minimum
capital requirement, will have little relationship to future exposures
or the related collateral requirements of derivatives contracts
throughout the stress test. For this second reason, OFHEO also
disagrees with GE Capital's suggestion that the stress test apply lower
haircuts to collateralized exposure on interest rate derivative
contracts as of the start of the stress test.
The final rule retains the haircuts for derivative contract
counterparties proposed in NPR2 for securities rated triple-A, double-
A, single-A and triple-B. Like other haircuts, they are phased in
linearly in the first five years of the stress period. Haircuts for
derivative contract counterparties are now higher relative to the
haircuts applied to other counterparties as a result of the reduction
in haircuts for those other counterparties in the final rule, but they
remain substantially less than haircuts for nonderivative
counterparties.
For certain derivative contract counterparties, the practical
difficulties of modeling the instruments according to their terms
require the use of simplifying assumptions. (See, e.g. discussion under
section III.J.4., Foreign Exchange Risk.) For these few instruments, no
haircut is applied. When the simplifying assumptions are no longer
needed, these counterparties will be subject to haircuts comparable to
those for other derivative counterparties.
3. Rating Categories
NPR2 proposed applying haircuts based on public ratings and
treating unrated counterparties and investments as if they were rated
triple-B and below, the lowest haircut category. In the case of
different ratings from different rating agencies, the lowest rating
would be used.
a. Comments
Most commenters who addressed the issue supported the use of public
ratings, but there was disagreement about OFHEO's treatment of below-
investment-grade and unrated counterparties and securities. Some
commenters suggested that no credit should be given in the stress test
for enhancements provided by unrated or below-investment-grade
counterparties. Although the Enterprises supported the rating
categories OFHEO proposed, Fannie Mae, along with other commenters,
asserted that the assignment of unrated seller/servicers to the triple-
B category overstated counterparty risk, especially with respect to
Delegated Underwriting and Servicing (DUS) lenders, whose agreements
are typically supported by other credit enhancements, such as letters
of credit. For these lenders, Fannie Mae suggested reliance on an
Enterprise's internal rating classifications. Fannie Mae also suggested
reliance on internal ratings when fewer than two ratings are available,
or when additional contractual agreements supporting the counterparty
obligation exist. In addition, Fannie Mae suggested that relationships
with corporate parents might justify an assignment of a parent
company's rating to its unrated seller/servicer subsidiaries (rather
than the triple-B rating proposed for unrated seller/servicers) for
purposes of the stress test. Both Fannie Mae and Freddie Mac
recommended that, in the case of split ratings, the stress test apply
the median.
b. OFHEO's Response
The final rule makes no change to the proposed treatment of split
ratings because OFHEO believes that a conservative evaluation of risk
is appropriate for regulatory purposes. Consistent with that belief,
and in response to comments, the final rule
[[Page 47777]]
introduces a new haircut category for nonderivative securities and
counterparties (except seller/servicers and GSEs) that are rated below
investment grade or unrated. The new haircut category recognizes the
significant distinctions between the default experience of triple-B-
and double-B-rated corporate bond issuers, as reflected in the Moody's
data, and the fact that the lack of a public rating often reflects the
speculative nature of the credit. The new haircut category is assigned
a haircut of 100 percent and is applied in the first month of the
stress period. The effect of applying a 100 percent haircut in the
first month of the stress period is to write off as a loss below-
investment-grade or unrated securities (except securities issued by
GSEs), and to give no credit for credit enhancements or derivatives
provided by below-investment-grade or unrated counterparties (except
seller/servicers). However, to provide for investments that are unrated
for reasons other than an inability to obtain a public rating, OFHEO
reserves the right to make a different determination on an unrated
counterparty or security that would otherwise be subject to the 100
percent haircut, on a case-by-case basis, if an Enterprise presents
information about the investment that persuades OFHEO that a different
rating is warranted.
The Enterprises do not currently contract with mortgage insurers or
derivative contract counterparties that are below investment grade or
unrated, and OFHEO has issued policy guidance \144\ to the Enterprises
emphasizing the importance of high-quality investments for their
liquidity portfolios. OFHEO would view the practice of investing in
below-investment-grade securities or contracting with below-investment-
grade counterparties unfavorably. The introduction of the new haircut
category should have little impact on the Enterprises' capital
requirements as they currently conduct their businesses, but it will
make the risk-based capital regulation consistent with OFHEO's
regulatory policy on below-investment-grade investments.
---------------------------------------------------------------------------
\144\ OFHEO Director's Advisory, Non-mortgage Liquidity
Investments, PG-00-002 (Dec. 19, 2000).
---------------------------------------------------------------------------
Under the final rule, unrated seller/servicers continue to be
treated as if they were rated triple-B, in recognition of the ongoing
nature of the Enterprises' relationship with seller/servicers and the
contractual leverage available to the Enterprises to manage their
exposure to counterparty risk, as well as the credit protection
afforded by servicing income and mortgage insurance premiums. OFHEO
rejected the recommendation to use internal Enterprise ratings for
unrated seller/servicers, for reasons articulated in NPR2.\145\ Neither
the Enterprises' internal ratings methodologies nor the ratings
themselves are publicly available, and they may not be consistent with
each other. OFHEO also declines to assign the rating of a parent
company to its unrated seller/servicers subsidiary, just as the NRSROs
will not impute a corporate parent's rating to a derivative dealer or
credit enhancement counterparty in the context of rating a securities
transaction. To do so would require OFHEO itself to ``rate'' the
entity, considering the nature and extent of a parent's liability for
an entity's obligations.
---------------------------------------------------------------------------
\145\ 64 FR 18155, April 13, 1999.
---------------------------------------------------------------------------
OFHEO recognizes the desirability of making finer risk distinctions
between unrated seller/servicers in a risk-based capital regulation.
Therefore, following adoption of this regulation OFHEO will evaluate
alternative approaches for assessing the risk of unrated seller/
servicers, including establishing criteria under which Enterprise
internal ratings could be used, and encouraging the attainment of a
NRSRO rating by seller/servicers.
In response to comments that NPR2 did not reflect adequately the
risk-mitigating requirements of the DUS program, OFHEO notes the
following. DUS lenders, like all seller/servicers, benefit from this
favored treatment in addition to the general reduction in haircut
levels. Further, the letters of credit that DUS lenders typically post
to back up their loss sharing agreements will be modeled, providing a
significant offset to the haircut. In addition, DUS lenders are among
those who benefit from the inclusion of two variables in the
multifamily default model, the New Book indicator and the Ratio Update
Flag. The New Book indicator captures the lower default probability for
loans acquired under the Enterprises' current multifamily lending
programs compared to loans acquired under early loan programs. The
Ratio Update Flag reflects the lower default probability for loans on
which the underwriting ratios have been reviewed and adjusted at
acquisition to Enterprise standards. The effect of these various
elements of the stress test is to create substantially lower losses on
loans from the DUS or similar programs than on loans that share none of
the risk mitigating factors of DUS loans.
An exception to the new haircut category is also made for unrated
securities issued by other GSEs. NPR2 stated that the stress test
reflects no credit losses on securities issued by Ginnie Mae or the
Enterprises,\146\ but did not address whether a haircut should be
applied to payment due to an Enterprise from securities issued by
another GSE. The final rule clarifies that this statement was not
intended to apply to securities issued by another GSE held by an
Enterprise as an investment (including a Fannie Mae security held by
Freddie Mac or a Freddie Mac security held by Fannie Mae). Such unrated
securities are treated as AAA-rated securities and haircut accordingly.
---------------------------------------------------------------------------
\146\ See id.
---------------------------------------------------------------------------
To summarize, the haircuts used in the final regulation to discount
for all counterparty risk are set forth by rating category and
counterparty type in Table 6.
Table 6.--Haircuts by Rating Category in Final Rule
------------------------------------------------------------------------
Non-
Ratings Classification Derivatives derivatives
------------------------------------------------------------------------
AAA 2% 5%
------------------------------------------------------------------------
AA 4% 15%
------------------------------------------------------------------------
A 8% 20%
------------------------------------------------------------------------
BBB 16% 40%
------------------------------------------------------------------------
Below BBB & Unrated \1\ 100% 100%
------------------------------------------------------------------------
\1\ Unrated, unsubordinated obligations issued by other GSEs are treated
as AAA. Unrated seller/servicers are treated as BBB. Other unrated
counterparties and securities are subject to a 100% haircut applied in
the first month of the stress test, unless OFHEO specifies another
treatment, on a showing by an Enterprise that a different treatment is
warranted.
4. Foreign Exchange Risk
In NPR2, OFHEO proposed to model foreign currency derivative
contracts that fully hedge the foreign exchange risk of liabilities
issued in foreign currencies as synthetic dollar-denominated
liabilities. Under the proposal, appropriate haircuts would be
determined by increasing amounts of principal and interest due on the
synthetic liabilities by the amount of the derivative contract haircut
appropriate to the counterparty.\147\ (Applying the same approach to
contracts hedging
[[Page 47778]]
foreign-currency-denominated assets, amounts received from a synthetic
asset would be reduced by the same percentage.) To the extent foreign
exchange risk exposure is not fully hedged, NPR2 proposed to assume an
adverse percentage change in the value of the foreign currency versus
the United States dollar equal to the amount of the percentage change
in the ten-year CMT, which resulted in a significantly larger
haircut.\148\ OFHEO did not propose to apply netting provisions to
foreign currency derivatives, because netting of all of a
counterparty's derivative contracts would require the modeling of all
of their cash flows. Accordingly, instead of modeling all cash flows
for foreign-currency-denominated contracts, NPR2 simply adjusted the
debt payment amounts.
---------------------------------------------------------------------------
\147\ Theoretically, the haircut should be applied based on the
amount of foreign currency to be paid to the Enterprise in the
transaction. However, these amounts cannot be calculated, because
foreign currency values are not projected in the stress test.
Therefore, for purposes of computing a capital number for a currency
swap, using the dollar side of the transaction is used as the basis
to determine total cash flow haircuts.
\148\ NRP2 provided that in the event OFHEO finds that the
foreign currency risk on any liability or derivative instrument has
not been transferred fully to a third party, the stress test would
model the instrument by creating significant losses in both the up-
rate and down-rate scenarios. In the up-rate scenario, the stress
test would apply an exchange rate that increases the value of the
foreign currency against the dollar by the same percentage that
interest rates increase. In the down-rate scenario, the stress test
would decrease the exchange rate of the dollar proportionately with
the decline in the 10-year CMT, creating a decrease in the value of
the dollar similar to that in the up-rate scenario.
---------------------------------------------------------------------------
a. Comments
Fannie Mae supported the modeling of foreign-currency-denominated
debt and associated foreign currency swaps as synthetic dollar-
denominated instruments, but commented that the resulting haircuts were
excessive. It pointed to the lack of netting of payments within an
individual swap and among payments across all swaps with a single
counterparty, and the fact that the haircuts would be consistently
applied, whether a derivative was ``in the money'' or out ``of the
money.'' \149\ The Enterprise suggested that for foreign exchange
contracts, the minimum capital standard, which ``provides for generally
higher capital charges for foreign exchange contracts than other types
of derivative contracts,'' should apply. Fannie Mae also commented that
OFHEO should delete from the final regulation the NPR2 treatment for
unhedged foreign currency transactions, because none currently exist in
Fannie Mae's book of business. Finally, Fannie Mae objected to a
footnote in the preamble to NPR2 that indicated that the same type of
treatment used for foreign currency derivatives would be applied to any
instrument that was denominated in or linked to units or values that
are not included in the stress test.\150\ Fannie Mae stated that this
footnote would create a bad precedent and that any such instrument
should be dealt with on a case-by-case basis.
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\149\ A foreign currency swap is ``in the money'' when net funds
are due to the Enterprise under the contract and ``out of the
money'' when the Enterprise owes net funds under the contract.
\150\ 64 FR 18158 n. 168, April 13, 2000.
---------------------------------------------------------------------------
b. OFHEO's Response
The final rule does not adopt Fannie Mae's recommendation to employ
netting within a swap or among all swap payments with a single foreign
currency swap counterparty. The synthetic debt approach is inconsistent
with netting because it effectively models only the dollar-denominated
pay side of a swap, not the foreign-currency-denominated receive side.
Without modeling both sides of a swap, netting of the payments
associated with such derivatives is not feasible. OFHEO takes an
appropriately conservative approach by treating foreign currency
derivatives as always being ``in the money'' because, without
explicitly modeling foreign currencies, there is no basis for
determining whether a contract is ``in'' or ``out of the money.'' OFHEO
also rejects the application of minimum capital treatment for
derivatives for reasons discussed above at section III.J.2.b., OFHEO's
Response. However, because foreign currency values are not projected in
the stress test, OFHEO has decided not to apply haircuts to foreign
currency swap counterparties by adding the haircut percentage to the
pay side of the swap. As a simplifying assumption, no haircut is
applied in the final rule. However, OFHEO continues to believe that
some haircut is appropriate and will continue to explore whether some
other methodology is more appropriate.
Notwithstanding Fannie Mae's comment that it currently has no
unhedged foreign currency exposure, it is conceivable that unhedged
positions could arise, because the Enterprises issue securities
denominated in foreign currencies and use foreign currency derivatives
to hedge the exchange risks associated with these securities. For this
reason, the final rule retains a treatment for them. If the Enterprises
follow their current policies and continue to use swaps to fully hedge
all foreign currency risk, the treatment of unhedged positions in the
regulation will be a moot issue. If these policies change, or through
error or inadvertence are adhered to imperfectly, the regulation
includes an appropriately conservative treatment to deal with any
instruments that are left unhedged.
In regard to the footnote related to instruments that are
denominated in, or linked to, units or values that are not included in
the stress test, OFHEO will consider such instruments, including
unhedged derivatives (other than standard interest rate or foreign
currency derivatives) or other unusual instruments that appear at the
Enterprises, on a case-by-case basis. Where the stress test includes a
specific treatment or the capability to model the instrument according
to its terms, OFHEO will do so. Other instruments may be accorded
alternative modeling treatments in accordance with section 3.9,
Alternative Modeling Treatments, of the Regulation Appendix. The
footnote was intended to indicate that a treatment similar to that for
unhedged foreign currency exposures would likely be appropriate for
such instruments. If the instruments involve a new activity for an
Enterprise, it should notify OFHEO as soon as possible of the existence
of the transaction and request an estimated treatment in the stress
test in accordance with section 3.11, Treatment of New Enterprise
Activities, of the Regulation Appendix.
5. Mortgage Insurer Distinctions
NPR2 proposed haircuts that double for every decrease in rating
category for all securities and counterparties, other than unhedged
foreign currency derivative contract counterparties, without
distinguishing between types of counterparties.
a. Comments
MICA and Triad GIC argued for preferred treatment for mortgage
insurers rated triple-A and double-A over securities and other types of
counterparties, and, along with Neighborhood Housing, opposed
differentiating between mortgage insurers rated triple-A and double-A.
MICA emphasized that mortgage insurance companies' ratings are based
solely on their ability to manage and absorb mortgage credit risk
losses in a stress scenario and cited the effectiveness of state
insurance regulation. Several other commenters, including another
mortgage insurer, urged OFHEO to maintain the distinction.
b. OFHEO's Response
OFHEO believes that NRSROs take into account all of the relevant
risk characteristics when assigning ratings, including those cited by
the commenters, and seek to maintain comparability of the ratings as
risk indicators across industries. Therefore, in the absence of
quantitative data demonstrating a better credit performance of mortgage
insurance companies versus similarly rated
[[Page 47779]]
entities and securities, OFHEO has not given preferential treatment to
mortgage insurers in the final rule. The final rule also maintains the
distinction between triple-A- and double-A-rated counterparties and
securities because performance differences between the two are
reflected in the data irrespective of the level of stress.
6. Rating Agencies
In NPR2 OFHEO proposed to use rating information from four NRSROs,
S&P, Moody's, D&P, and Fitch ICBA, for all counterparties and
securities other than seller/servicers. For seller/servicers, NPR2
proposed to use only rating information from S&P and Moody's for
seller/servicers providing mortgage credit enhancements. Freddie Mac
and Fitch ICBA recommended that the rule use credit ratings by all
NRSROs for all counterparties, and OFHEO has adopted this approach in
the final rule.
7. Collateralized Securities
Both Fannie Mae and Freddie Mac commented that the stress test
should not haircut investments if (1) they are backed by collateral
representing obligations of the U.S. Government (e.g., Ginnie Mae
securities or FHA-insured loans) or of GSEs; and (2) the collateral is
held by a trustee. Fannie Mae also suggested that haircuts for mortgage
revenue bonds based on security ratings would be excessive, due to
double counting the risk of any collateral guaranteed by the
Enterprise.
The final rule continues to treat these investments consistently
with other investments because OFHEO believes that NRSROs strive to
achieve consistency in the risk assessments represented by their
ratings. A rating reflects the rater's overall assessment of the
likelihood an investor will receive all contractually required
principal and interest. A rating of less than triple-A reflects the
rater's perception of an element of risk in some aspect of a security
or its structure, such as the legal structure or the role of a third
party in the transaction, even when some or all of the collateral
represents obligations of the Federal Government or a Government-
sponsored Enterprise. Further, OFHEO does not believe the haircutting
of MRBs results in material double counting of the credit risk of any
Enterprise collateral. Rating agencies treat such collateral as triple-
A, so the risk associated with any lower rating on the collateralized
security reflects risk factors not related to the collateral.
8. Private Label Security Haircut
NPR2 proposed to apply haircuts to payments due to an Enterprise
from private label securities (municipal, corporate and mortgage- or
asset-backed) based on the security's credit rating, consistent with
the treatment of all securities and counterparties other than interest
rate and foreign currency derivative contract counterparties. Thus, the
proposal would have subjected unrated securities to a haircut
appropriate to a rating of double-B or below. In the final rule,
private label securities, like all other securities, will be assigned a
100 percent haircut if they are rated double-B or lower or are unrated.
OFHEO did not adopt Freddie Mac's suggestion that unrated
securities should receive haircuts based on the rating of the issuer,
because there are circumstances in which the credit rating for an
issuer might not be appropriate for an unrated security. For example,
for many securities there is no contractual requirement for an issuer
to provide credit support. Furthermore, evaluating contractual
obligations of individual issuers for specific securities would add
complexity to the stress test that would impede its operational
workability and would not be justified by any marginal benefit derived.
K. Mortgage Credit Enhancements
NPR2 proposed to offset stress test losses with the credit
enhancements used by the Enterprises.\151\ NPR2 generally distinguished
between ``percent denominated'' enhancements (e.g., primary mortgage
insurance), where the coverage is based on a percentage of the loss
incurred, and ``dollar denominated'' enhancements (e.g., pool
insurance) where the coverage available is expressed as a specified
dollar amount, which is applied to offset credit losses on a pool of
loans until the coverage is exhausted.\152\ For all credit
enhancements, the available coverage was reduced by a ``haircut'' based
on the counterparty's public rating.\153\ (See III.J., Other Credit
Factors.)
---------------------------------------------------------------------------
\151\ The Charter Acts prohibit the purchase of conventional
single family mortgages with LTV ratios in excess of 80 percent
unless: (1) The seller retains a participation interest of 10
percent or more; (2) the seller agrees to repurchase or replace the
mortgage upon default; or (3) the amount of the mortgage in excess
of 80 percent is insured or guaranteed. For reasons stated in NPR2,
the proposed stress test did not, and the final stress test will
not, recognize any credit enhancements on any such mortgages that do
not meet one of these three conditions. When this statutory
requirement is applicable and is met, the stress test will recognize
all credit enhancements related to the loan. See 64 FR 18156, April
13, 1999.
\152\ Percent-denominated credit enhancements included mortgage
insurance and unlimited recourse and unlimited indemnification.
Mortgage insurance coverage is a percentage of the gross claim
amount and unlimited recourse and unlimited indemnification cover
100 percent of the net loss amount. All other types of credit
enhancements currently used by the Enterprises were considered
dollar-denominated. The final rule distinguishes between loan limit
credit enhancements and aggregate limit credit enhancements, which
correspond to the NPR2 designations of percent- and dollar-limit
credit enhancements, respectively, except that in the final rule,
for computational convenience, unlimited recourse and unlimited
indemnification are treated as aggregate limit credit enhancements
(limited to the aggregate original UPB of the covered loans).
\153\ A ``haircut'' is a reduction in the credit enhancement
coverage available that is based on the public rating of the
provider to reflect the risk that the stress of the stress period
will cause the provider to default on some of its obligations. See
section III.J., Other Credit Factors for a discussion of haircuts.
---------------------------------------------------------------------------
NPR2 proposed to apply credit enhancements at the loan group
level.\154\ Because pools of loans covered by a particular credit
enhancement contract could be distributed among more than one loan
group, NPR2 proposed simplifications in the treatment of such
contracts. Specifically, for dollar-denominated credit enhancements,
NPR2 proposed allocating amounts available under the contract to each
affected loan group based on the ratio of the aggregate balance of
loans in the loan group covered by the enhancement, to the aggregate
balance of all loans covered under the contract. As proposed in NPR2,
for each loan group, the proposed stress test aggregated funds
available under all dollar-denominated credit enhancements subject to
the same credit rating, applied the amounts available to loan group
losses each month of the stress period, and tracked the balances of the
funds allocated to each loan group throughout the stress period.
---------------------------------------------------------------------------
\154\ Loan groups are created by grouping loans of the same
type, origination year, original LTV, original coupon, Census
Division, and remittance cycle. (See section 3.1, Data, of the
Regulation Appendix.)
---------------------------------------------------------------------------
When loans are covered by more than one type of credit enhancement,
the stress test proposed in NPR2 would apply percent-denominated credit
enhancements first and then apply dollar-denominated enhancements to
cover any remaining losses. In such cases, to determine ``haircuts''
for counterparty credit risk, the proposed stress test assigned the
credit rating associated with the first level of credit enhancement for
a given loan (usually primary mortgage insurance) to all secondary
credit enhancements,\155\
[[Page 47780]]
which might differ from the haircut appropriate for the contract credit
enhancement counterparty.
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\155\ For example, if 50 percent of a loan group carried primary
mortgage insurance with an AAA-rated carrier, haircuts associated
with an AAA rating would be applied to any subordinate credit
enhancement coverage on those loans.
---------------------------------------------------------------------------
OFHEO believed this approach to modeling mortgage credit
enhancements struck a balance between precision and practical
implementation. OFHEO recognized that the approach could understate the
benefits of some and overstate those of other credit enhancement
contracts, but believed that the overall impact on stress test results
would likely be minimal.
A common theme of the comments on the treatment of mortgage credit
enhancements proposed by NPR2 was that mortgage credit enhancements
should be modeled at a greater level of detail. Commenters expressed
concerns about the impact of modeling simplifications, the failure to
model revenue inflows into spread accounts, and the modeling of
termination of credit enhancement coverage. In addition, several
commenters made suggestions about how OFHEO should treat credit
derivatives, including the Mortgage Default Recourse Note (MODERN)
transaction that was introduced recently by Freddie Mac. NPR2 did not
specify a treatment for credit derivatives, because, with the exception
of the MODERN transaction, the Enterprises had not been using them. The
cash flows from the MODERN transaction could be modeled like other
instruments that are modeled according to their terms and did not
present any unique issues. Comments on these issues are discussed below
by topic.
1. Modeling Simplifications
a. Contract Detail
(i) Comments
Both Enterprises criticized the simplified treatment of dollar-
denominated credit enhancements. Fannie Mae argued that the
``underlying parameters'' of contractual agreements between an
Enterprise and the credit enhancement counterparty should be modeled,
because in some cases the approach taken in NPR2 would not be
consistent with economic risk. Fannie Mae supported the modeling of all
credit enhancement contracts according to their terms. For example, in
the case of a contractual agreement that provides for the statutory
minimum level of primary mortgage insurance on a particular lender's
loans with LTVs in excess of 80 percent and a supplemental dollar-
denominated coverage in the form of a pool policy that applies to the
entire pool, Fannie Mae suggested that the stress test should apply the
primary coverage only to that lender's loans with LTVs greater than 80
percent and that the supplemental coverage should be applied in
accordance with the terms of the contract.
Freddie Mac commented that OFHEO's simplified treatment of dollar-
denominated credit enhancements would provide the Enterprises with the
benefit of some coverage to which they would not be entitled, and would
fail to provide the benefits of some overlapping coverage to which they
would be entitled. Freddie Mac also criticized the simplified structure
because it did not accommodate credit enhancement contracts with
specialized features. Freddie Mac argued that the complexity necessary
to model the contractual terms of credit enhancements explicitly is
justified by the need to assess accurately the value of the mortgage
credit enhancements because more than 30 percent of its portfolio is
credit enhanced beyond primary mortgage insurance.
(ii) OFHEO's Response
In response to Enterprise comments, OFHEO explored a method of
modeling dollar-denominated credit enhancements that tracks amounts
available under such credit enhancements by contract, rather than by
loan group, charging payments to an Enterprise made under any such
enhancement against the related contract, regardless of which loan
groups are involved. This approach required the creation of a finer
aggregation of loans below the loan group level, called Distinct Credit
Enhancement Combinations (DCCs). DCCs identify the principal amount of
loans in a loan group that have equivalently identical credit
enhancement arrangements. The creation of DCCs permits the aggregation
across all affected loan groups of deposits into and payments from each
individual credit enhancement and the consideration of its specific
rating and application priority. OFHEO found, however, that the
implementation of this treatment is exceedingly complex and greatly
increases the time required to run the stress test. OFHEO will continue
to explore how this more precise modeling might be done more
efficiently, but found it impracticable to incorporate the method in
the stress test at this time.
The final rule adopts a more limited use of DCCs. While it ensures
that haircut levels for aggregate limit credit enhancements are
consistent with specific counterparty ratings and application priority,
it does not track deposits to and withdrawals from such enhancements at
the contract level. Rather, the Enterprises report credit enhancement
available balances adjusted for deposits that can reasonably be
expected to be made during the stress period. These adjusted balances
are prorated among DCCs, based on the ratio of covered loan UPB at the
DCC level to the total UPB of loans covered under the credit
enhancement contract. For each DCC, the stress test then separately
tracks withdrawals from such prorated enhancement amounts under a given
contract to offset covered losses.
With regard to Fannie Mae's concern over the treatment of primary
mortgage insurance combined with pool insurance, the use of DCCs in the
final rule ensures that mortgage insurance coverage is applied only to
covered loans and that pool insurance or other aggregate limit credit
enhancement is then applied to all loans covered by the contract.
b. Ratings Detail
A number of commenters pointed out that the assignment of the
ratings of providers of primary credit enhancements to all supplemental
enhancements almost always overestimates the total credit enhancement
coverage where the primary layer is triple-A-rated mortgage insurance,
and may understate credit enhancement coverage where the primary layer
is an unrated seller/servicer. They asserted that this effect creates
an incentive to provide a thin primary triple-A layer of credit
enhancement, supplemented by an extensive and lower cost credit
enhancement from a lower rated institution.
In NPR2, OFHEO recognized that the application of the ratings of
the providers of primary credit enhancement to secondary credit
enhancements could understate or overstate the creditworthiness of
secondary credit enhancements, but thought the impact of this
simplification would likely be small. Nevertheless, in considering the
comments, OFHEO weighed the additional complexity that would result
from taking into account the actual rating of the supplemental provider
against the disadvantages and perverse incentives that the commenters
pointed out and concluded that the proposed stress test should be
modified. Accordingly, the final regulation takes into account the
rating of the supplemental credit enhancement rather than assigning the
credit rating of the primary credit enhancement provider.
[[Page 47781]]
c. Cash Accounts
In NPR2, OFHEO proposed to model mortgage credit enhancements that
take the form of cash accounts by aggregating them with all other
dollar-denominated credit enhancements, netting applicable haircuts,
and offsetting losses dollar for dollar until the amount of coverage is
exhausted.
The final rule models cash accounts more explicitly. It does not
aggregate them with all other dollar-denominated credit enhancements
and does not apply haircuts. However, if the cash is permitted to be
invested in securities with maturities longer than one year, the value
of the account is discounted by 30 percent to reflect the risk that the
value of the investments may be lower than par when they are required
to be liquidated to offset losses. When these investments are sold
prior to maturity, there is a risk that the price may be significantly
less than par because of changes in interest rates or market conditions
that occur between the time the investments are marked to market and
the time they are liquidated. This treatment is consistent with the
practice of rating agencies of requiring overcollateralization or
applying a discount factor to achieve sufficient certainty that the
market price at least equals the required amount of credit enhancement
at any time.
2. Credit Enhancements Receiving a Cash Flow Stream
Some dollar-denominated credit enhancements--primarily spread
accounts--are funded by a portion of each loan interest payment. The
proposed stress test took into account the amount of cash in the credit
enhancement account at the start of the stress test, but did not
attempt to model cash flows into the account during the stress period.
The Enterprises and others criticized this feature of the stress test.
In response to these comments, the final regulation allows the
Enterprises to take account of these cash inflows by adjusting the
available balance at the start of the stress test to reflect inflows
that might reasonably be expected to occur during the stress period.
These adjusted initial balances are then used to offset covered losses
during the stress period.
3. Termination Dates
Freddie Mac noted that, although OFHEO stated in NPR2 that the
coverage expiration date for credit enhancement contracts is required
as an input, OFHEO's cash flow model did not actually take it into
account.
This apparent inconsistency resulted from OFHEO's efforts to
respond to the enactment of the Homeowner's Protection Act of 1998
(HPA) \156\ shortly before NPR2 was published. The HPA, which applies
to loans originated after July 1, 1999, provides for the automatic
termination of mortgage insurance when the loan balance is scheduled to
reach 78 percent of the original value of the property securing the
loan,\157\ if payments on the loan are current. However, the adjustment
of the stress test to reflect this change was not yet accomplished when
NPR2 was published on April 13, 1999.
---------------------------------------------------------------------------
\156\ Pub. L. 105-216, 112 Stat. 897-910 (1998) (12 U.S.C. 4901-
4910).
\157\ FHA loans and ``high risk'' loans, as defined by the
Enterprises, are exempt from this provision.
---------------------------------------------------------------------------
As a result of events that have transpired since 1998, OFHEO has
decided to modify the stress test to terminate mortgage insurance on
all loans that amortize below 78 percent LTV. The public discourse
surrounding the enactment of the HPA and the notification policies of
many lenders have raised consumer awareness of the option to cancel,
making it increasingly likely that those borrowers will cancel mortgage
insurance as soon as it is possible to do so. Accordingly, the final
regulation specifies that mortgage insurance is terminated for all
loans, whenever originated, when the loan is amortized below 78 percent
LTV. For other types of credit enhancements, the stress test takes
contract expiration dates into account.
4. Treatment of Credit Derivatives
Credit derivatives are contractual instruments that link payment or
receipt of funds to the credit losses (which could include a rating
change on a security or a default that affects payments) on an
underlying asset or pool of assets. Treatments for credit derivatives
were not specified in NPR2. Nor did NPR2 specify counterparty haircuts
for credit derivatives.\158\ Commenters, therefore, questioned whether
the treatment of interest rate derivatives was intended to apply to
credit derivatives. If not, these commenters asked precisely how credit
derivatives would be modeled and, specifically, what haircuts are
appropriate for counterparties to these transactions.
---------------------------------------------------------------------------
\158\ The proposed rule provided a detailed description of the
cash flows that would be modeled for interest rate derivatives and
described treatments for foreign currency swaps. NPR2 also specified
a schedule of ``haircuts'' that would be applied to net amounts due
to an Enterprise from counterparties in derivative transactions. 64
FR 18157-18159, 18292-18296, April 13, 1999.
---------------------------------------------------------------------------
A number of commenters addressed the general issue of how credit
derivatives should be modeled. Also, several commenters addressed a
type of instrument called a Mortgage Default Recourse Note (MODERN),
which was used by Freddie Mac as part of a broader transaction to hedge
mortgage credit risk. The MODERNs can be considered credit derivatives
because the amounts of payments on them are ``derived'' from the
performance of a fixed reference pool of mortgages, but do not flow
through from the mortgages and are not secured by the mortgages. The
two groups of comments, which raised different issues, are dealt with
separately below.
a. Credit Derivatives in General
The use of credit derivatives to hedge credit risk of mortgages is
a new practice at the Enterprises, which currently comprises an
insignificant volume of transactions. However, OFHEO recognizes that,
as happened with interest rate derivatives, this activity could grow
significantly in the coming years. Therefore, the stress test must be
sufficiently flexible to deal with these instruments appropriately as
they arise. Credit derivatives are also far less standardized in type
and form than interest rate derivatives. They can be structured to
include only a small degree of counterparty risk to the Enterprises,
like the MODERN transaction, or to create large exposure to
counterparties. Depending upon their structures, these instruments can
also create significant modeling complexities.
(i) Comments
The comments reflected two schools of thought on the general
subject of credit derivatives. Commenters from the mortgage insurance
industry recommended that these instruments be analyzed separately from
other types of derivatives and as the subject of a separate rulemaking
proceeding. They emphasized that the market for credit derivatives is
still relatively small, that documentation is not standardized, and
that counterparties do not come from a monoline industry dedicated to
insuring mortgage credit losses. These commenters urged that OFHEO
should use a cautious approach in assigning haircuts to counterparties
in credit derivative transactions until the market for these
instruments is better developed and subject to more specific
regulations and protections. They also sought clarification that the
discussion of the treatment of derivatives in NPR2 was intended to
apply only to contracts that transfer interest rate risk.
[[Page 47782]]
The Enterprises and two investment banking firms expressed a
different view. They view the market and documentation for any credit
derivatives the Enterprises might use as well developed and similar to
that for interest rate derivatives. Fannie Mae commented that
collateralized credit-linked securities or risk transfers with well-
capitalized firms with diversified books of business can reduce overall
risk exposure, because derivative contract counterparties may be able
to absorb losses better than mortgage insurers.
(ii) OFHEO's Response
OFHEO considered all of these comments. The credit derivatives
market is relatively small at present, as reflected in the minimal
volume of these instruments at the Enterprises. Accordingly, OFHEO has
decided that it would be inappropriate at this time to issue a blanket
treatment that would be applicable to all credit derivatives.
OFHEO agrees with the mortgage insurers that, at present, credit
derivatives should be analyzed separately from other derivatives.
However, OFHEO will not assume that all credit derivatives necessarily
raise structural concerns or weaknesses that require haircuts that are
more conservative than those applied to counterparties in similar
transactions. Nor does OFHEO agree that it is necessary to have an
additional rulemaking proceeding to deal with these instruments if and
when they arise at the Enterprises. As discussed below, OFHEO's
analysis of the MODERN transaction revealed that credit derivatives can
be structured in such a way as to offset an Enterprise's credit risk in
much the same manner as mortgage pool insurance, and it is consistent
with the purpose of the stress test to account for that transaction in
much the same manner as pool insurance. Likewise, if counterparty and
other risks associated with the instrument appear to be the same as
those of an interest rate or foreign currency derivative, it will be
treated in a similar manner. However, if those risks are significantly
different, OFHEO will impose some other appropriately conservative
treatment.
b. MODERN Transaction
The MODERN transaction was a unique form of mortgage credit
enhancement, developed by Freddie Mac, that involved the sale of
securities to investors. The MODERN transaction may be thought of as a
``credit derivative'' because payment to investors in the securities,
as well as payments to Freddie Mac, are determined from the credit
performance of a fixed pool of mortgages, which serves as a reference
asset. The transaction required creation of a trust that is
contractually obligated to pay amounts to Freddie Mac based on the
amount of credit losses on the reference pool. As consideration,
Freddie Mac pays the trust a fee or premium that, together with
earnings on the trust principal, is used to make interest payments to
purchasers of the bonds that are used to fund the trust, as well as any
payments due to Freddie Mac. These securities are issued in several
tranches. The principal of each security is reduced (together with
future interest payments), according to the priority of its tranche, as
amounts are required to cover losses on the reference pool. The bonds,
which are issued by a special purpose corporation and are not marketed
as Enterprise securities, are all rated single-A and below because they
carry a high probability that their entire principal will not be
repaid. For Freddie Mac, the MODERN transaction bears some similarity
to mortgage pool insurance, because Freddie Mac receives variable
payments, based upon the credit losses in a pool of mortgages, and
makes fixed payments, analogous to premiums.
(i) Comments
Comments were divided as to the appropriate treatment for the
MODERN transaction. Commenters from the mortgage insurance industry
took the position that it involves greater counterparty risk than
interest rate derivatives or mortgage insurance. Accordingly, those
commenters recommended giving no credit or subjecting payments to
Freddie Mac under MODERNs to greater haircuts than those applicable to
other types of counterparties, such as mortgage insurers. Freddie Mac
said that there is no counterparty risk in these transactions, and that
the payments to Freddie Mac cannot be reduced from the amounts required
under the contract due to financial failure of a counterparty. There is
no more risk of nonpayment in the MODERN transaction, argued Freddie
Mac, than in a mortgage-backed security or other asset-backed security
where a trustee is obligated to make payments when, and in the amounts
that are, due.
(ii) OFHEO's Response
After study of the MODERN transaction, OFHEO agrees that it does
create some credit risk (i.e., risk of default by a counterparty) to
the Enterprises. Although risk of loss may be low because the
transaction is structured to provide significant collateral, OFHEO does
not have the data necessary to analyze the adequacy of that collateral.
OFHEO finds the transaction most similar, structurally, to mortgage
pool insurance and will model it in a similar fashion, applying the
haircut that would be appropriate to a mortgage pool insurance
contract. However, future MODERN or other credit derivative
transactions will be analyzed based upon their specific terms and
similar treatments will not necessarily be found appropriate for them.
The final rule does not detail the specific treatment for the
MODERN transaction because it presents no new features that cannot be
modeled using the more general treatments that are specified. Like
other transactions that are modeled according to their terms, cash
flows on the MODERN transaction will be projected according to the
terms of its instruments and will be haircut based upon the credit
rating of the counterparty. Those terms are tied directly to credit
losses of a pool of Enterprise mortgage loans, which is modeled like
any other pool of loans in the stress test.
L. New Debt and Investments
The proposed stress test projected cash inflows and outflows for
each month of the stress period in order to determine the net
availability of cash. To the extent cash inflows exceed cash outflows
in any month, NPR2 specified how an Enterprise would employ the excess
funds. Conversely, to the extent that cash outflows exceed cash inflows
in any month, NPR2 specified how an Enterprise would obtain the funds
to cover the cash deficit. The net cash position for each of the 120
months of the stress period was calculated at the end of each month.
Depending upon whether the cash balance at the end of a month was
positive or negative, new debt or investment was added. Excess cash was
invested in one month maturity assets at a rate equivalent to the six-
month Treasury yield. If a cash deficit existed, new short-term debt
was added. NPR2 specified that the Enterprises would issue all new debt
as six-month discount notes at the six-month Federal Agency Cost of
Funds rate plus 2.5 basis points to cover issuance cost.
Comments are discussed below by topic.
[[Page 47783]]
1. Length of Debt Term
a. Comments
The proposal to fund all cash deficits with short-term instruments
received a number of comments, only one of which favored the proposal.
Most commenters that addressed the issue recommended that OFHEO provide
for a mix of long- and short-term debt instruments, to better reflect
the rebalancing strategies of the Enterprises. The Enterprises both
suggested that the rule be modified to add 80 percent long-term debt in
the up-rate scenario and 20 percent long-term debt in the down-rate
scenario. One commenter suggested that OFHEO allow the Enterprises to
use their internal models to project the appropriate mix of debt,
apparently presuming that OFHEO would adopt an internal models approach
to setting risk-based capital.
b. OFHEO's Response
After consideration of the comments and further analysis of the
issue, OFHEO determined that a more risk-neutral approach to
establishing the mix of long- and short-term debt is available and
practical and has implemented it in the final rule. That approach sets
a 50-50 target mix of long- and short-term debt for an Enterprise's
portfolio and projects issuance of debt each month that will move the
Enterprise toward that target and maintain that mix once it is reached.
The 50-50 mix was selected because an Enterprise cannot know from month
to month whether interest rates will go up or down and OFHEO will not
try to model Enterprise predictions.
Notwithstanding the contrary views of some commenters, OFHEO has
found it neither practical nor desirable to attempt in the stress test
to predict the reactions of Enterprise management to interest rate
shocks. Both Enterprises adjust the mix of maturities in their debt
portfolios frequently, based upon the anticipated duration of their
assets. The Enterprises have different policies designed to mitigate
interest rate risk by matching the durations of assets and liabilities.
They use sophisticated computer models to provide insights into future
interest rate patterns and to monitor duration mismatches in their
portfolios. These models allow the Enterprises to adjust their issuance
of liabilities and their derivatives positions daily to comply with
their internal policies. However, as several commenters recognized,
attempting to approximate this decision-making process in the stress
test is impractical. Further, doing so would cause the stress test to
create additional hedges and risks in the Enterprises' books of
business, which, in OFHEO's view, is contrary to the intent of the 1992
Act. For those reasons, OFHEO has adopted an approach that is not
biased toward long- or short-term debt in either interest rate
scenario.
The practical difficulties associated with attempting to develop a
simple rule that approximates the Enterprises' likely new debt issuance
is illustrated by an analysis of the refunding rules suggested in their
comments. The Enterprises suggest that new debt issuances be weighted
heavily to the long-term in the up-rate scenario and to the short-term
in the down-rate scenario. They contend that, given the impracticality
of predicting funding decisions, this simple methodology would provide
a reasonable approximation of their behavior. OFHEO disagrees that this
methodology provides such a reasonable approximation. The suggested
weightings may or may not reflect the way the Enterprises respond to a
future interest rate shock, because they rebalance to achieve certain
balances in their portfolios, not in their issuances. Accordingly,
whether they issue long- or short-term debt depends as much upon their
current debt, asset, and derivative positions as upon interest rate
movements.
Another factor in each Enterprise's funding decisions is its
expectations for interest rates. These expectations are based, at least
in part, upon historical models that, particularly under the extreme
conditions of the stress test, might project various outcomes, and
would, almost certainly, not project exactly the paths specified in the
stress test. In short, the Enterprises would have no way of knowing
that interest rates were going to continue moving quickly in the same
direction for a year and remain at an elevated or deflated level for
another nine years. However, despite this uncertainty, the Enterprises'
approach would add mostly long-term debt in the up-rate scenario,
increasing vulnerability to interest rate declines without regard to
the mix of liabilities in the existing portfolio. This approach would
have the effect of locking in relatively lower interest rates early in
the stress period and lowering debt costs (and, therefore, capital
requirements) significantly. Similarly, adding mostly short-term debt
in the down-rate scenario would allow an Enterprise to refinance with
lower cost debt regardless of the Enterprise's existing maturity mix,
although, as many commenters noted, an assumption that an Enterprise
will utilize predominately short-term funding is not realistic. It
should be noted, however, that OFHEO found the impact on capital of
short-term funding in the down-rate scenario was small, because rapid
prepayment of loans creates little need for new debt.
In sum, OFHEO adopted an approach that did not attempt explicitly
to predict or simulate Enterprise responses to the interest rate shocks
in the stress test. Instead, recognizing that any new debt will have
some effect on interest rate risk, OFHEO chose an approach that
reflects no bias toward long- or short-term debt in either interest
rate scenario.
2. Specific New Debt and Investment Instruments
a. Investment Instruments
Fannie Mae suggested that specifying an investment instrument with
a one-month maturity and a six-month rate is inappropriate, because
such instruments do not exist.
The final rule adopts the proposed rule and specifies that all cash
surpluses will be invested in one-month maturity assets with a six-
month Treasury yield. Recognizing that the instrument specified does
not exist in the marketplace, OFHEO chose it as a modeling
simplification that simulates the effect of a series of investments
made over successive months and ensures that each month there are
instruments that mature and are replaced in the portfolio. Using a
longer maturity would have resulted in greater fluctuations in cash
surpluses from month to month, causing the Enterprises to borrow money
in later months to cover instruments purchased with a temporary cash
surplus.
However, using a one-month rate for new investments would ignore
the fact that an Enterprise's actual return on new short-term
investments is based upon a number of different maturities between one
day and one year. The six-month rate was chosen as a reasonable
approximation of the average rate earned on those maturities.
b. Debt Instruments
Fannie Mae recommended that OFHEO change the proposed short-term
debt instrument from a six-month to a one-month maturity, but did not
explain any benefits from such a change. Nevertheless, OFHEO analyzed
whether, in light of other changes in the new debt approach, the short-
term debt instrument should be changed. OFHEO determined not to change
the instrument proposed in NPR2, because a six-month rate is more
representative of the mix of short-term maturities issued by the
Enterprises.
A few commenters recommended that the regulation specify ten-year
bullet (no
[[Page 47784]]
call) debt as the long-term debt instrument. Fannie Mae suggested that
OFHEO specify ten-year bullet debt as the long-term instrument during
the up-rate scenario and, in the down-rate scenario, three-year debt
callable in one year. OFHEO considered those options, but determined
that a five-year bond callable in one year was most appropriate. The
Enterprises issue a variety of debt with maturities greater than one
year, but with average maturities generally far less than ten years.
Also, they increasingly have come to rely upon callable debt to balance
the prepayment optionality in their loan portfolios. For these reasons,
OFHEO concluded that five-year callable debt was a more representative
proxy for long-term Enterprise debt than ten-year bullet or three-year
callable debt.
The Enterprises expressed concern that the regulation would not
take into consideration the linkage of the-short term debt in their
portfolios to interest rate swaps that result in effective long-term
rates and maturities. The Enterprises create this long-term ``synthetic
debt'' to take advantage of pricing anomalies in the debt and
derivatives markets. The final rule clarifies that in determining the
amount of short-term debt on the books of an Enterprise, the notional
value of debt-linked fixed-pay swaps is deducted from the total amount
of short-term debt and added to the total amount of long-term debt.
This procedure effectively converts the affected short-term debt to
long-term for purposes of the determining the mix of new debt.
3. Date of Issuance or Purchase
NPR2 specified that new debt is issued and new investments
purchased at the end of each month of the stress period based upon the
cash position at the end of the month. OFHEO determined that a more
correct modeling convention is to issue the debt or purchase the
investments at the midpoint of the month to reflect the fact that
financial instruments mature throughout a month, not at month end. The
final rule changes the issuance date to the 15th day of the month.
M. Cash Flows
1. Mortgage-Related Cash Flows
In NPR2, OFHEO described how the stress test would treat cash flows
from mortgage-related instruments during the stress period. Under the
proposal, the stress test would produce cash flows for single family
and multifamily mortgage loans that are held in portfolio and cash
flows for the same types of loans that are pooled into mortgage-backed
securities (MBS) that are guaranteed by the Enterprise. For retained
loans, the cash flows to the Enterprises are all the principal and
interest payments on the loans, except for a portion of the interest
payment retained by the servicer as compensation. For sold loans, these
cash flows are guarantee fees received by the Enterprises and float
income.\159\ Cash flows, net of credit losses, are produced for each
month of the stress period for each loan group using loan group
characteristics and information on interest rates; default, prepayment,
and loss severity rates; and third party credit enhancements.
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\159\ Float income is the earnings from the investment of
principal and interest payments on sold loans during the remittance
cycle for the period of time between the receipt of these payments
from the servicer and the remittance of those payments, net of
guarantee fees, to security holders. The length of time an
Enterprise can invest these payments depends on the length of that
period.
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Only Freddie Mac commented on the mortgage cash flow section of the
stress test. Specifically, Freddie Mac recommended that OFHEO specify a
different treatment for cash flows produced by adjustable rate
mortgages (ARMs) and modify the remittance cycle for MBS. These
comments and OFHEO's responses are discussed below.
a. Adjustable Rate Mortgages (ARMs)
In NPR2, OFHEO proposed to model ARM cash flows as if the loans all
adjusted annually and as if they all had the same margins and caps.
Under the proposal, all ARM loan groups were indexed to either the one-
or three-year CMT or the 11th District COFI.
Freddie Mac alleged that the proposed approach failed to capture
the impact of a substantial volume of ARM products that adjust monthly
or every six months and have different margins and caps. These
additional terms may result in extra income to the Enterprises.
Based on its analysis of ARM-related cash flows in light of Freddie
Mac's comment, OFHEO has determined that it is appropriate to modify
the stress test to model ARM cash flows according to their contract
terms as reported in the RBC Report. This change reflects the
importance of the full range of ARM products to the Enterprises,
particularly in relatively volatile interest rate environments.
Although the estimated default and prepayment rates for ARMs are
averages for all ARM product types, for reasons described in
III.I.1.h., Adjustable Rate Mortgages (ARMs), the stress test does
capture the cash flow differences by ARM product type, thereby
addressing Freddie Mac's comment. The respecified ARM model is capable
of modeling cash flows from all ARM products whose terms are reported
in the RBC Report according to those terms. This reflects the
importance of these product types to the Enterprises, particularly in
relatively volatile interest rate environments.
b. Remittance Cycles for Mortgage-Backed Securities (MBS)
In NPR2, OFHEO proposed to model only specific categories of MBS by
including the float amount for three remittance cycles. Specifically,
the stress test included remittance cycles only for Freddie Mac's
Standard and Gold Programs and Fannie Mae's Standard Program. The
stress test did not model additional programs.
Freddie Mac commented that under NPR2, only two of its three
principal remittance cycles are modeled. Freddie Mac stated its general
belief that where practicable, OFHEO should model the contractual terms
or actual characteristics of an instrument or make reasonable
simplifications.
Based on its analysis of MBS-related cash flows and in light of
Freddie Mac's comment, OFHEO has determined that it is appropriate to
modify the stress test to accommodate a wider range of remittance
cycles, rather than limit the modeling to three specific cycles.
Specifically, the final rule allows as an input, the number of float
days in a remittance cycle, rather than a specified number of
remittance cycles. The additional precision resulting from more refined
modeling of MBS reflects the significant volume of these products and
their importance to the Enterprises.
2. Nonmortgage Instrument Cash Flows
In NPR2, OFHEO specified the proposed treatment of cash flows from
nonmortgage instruments during the stress period in two sections of the
Regulation Appendix. Section 3.9.3, Debt and Related Cash Flows
detailed how the stress test would produce cash flows for instruments
such as debt, guaranteed investment contracts (GICs), preferred stock,
debt-linked derivative contracts, and mortgage-linked derivative
contracts. Similarly, section 3.9.4, Non-Mortgage Investment and
Investment-Linked Derivative Contract Cash Flows detailed how the
stress test would produce cash flows for instruments such as
nonmortgage assets and investment-linked derivative contracts. The cash
flows for debt, nonmortgage investments, and preferred stock included
interest (or dividends for preferred stock) and principal payments or
receipts. The cash flows for debt-linked, investment-linked, and
mortgage-linked derivative contracts
[[Page 47785]]
would include interest payments and receipts. NPR2 did not attempt to
provide detailed descriptions of the cash flow calculations of all
nonmortgage instruments that exist or might exist at the Enterprises.
The examples that were provided were illustrative.
a. Comments
Only MICA commented on NPR2's proposed treatment of nonmortgage
instrument cash flows. Although MICA generally agreed with the proposed
method of generating cash flows, it recommended that American-style
calls also be modeled. With American-style calls, the exact timing of
the exercise of the call option is not always known because the nature
of the American-style call allows the issuer to exercise its call at
any time between the first call date and the final call date.
b. OFHEO's Response
American-style calls were modeled in NPR2, but, as a simplifying
assumption, were treated as Bermudan-style calls, which are evaluated
for exercise on each coupon payment date following the start date of
the option. OFHEO agrees that it would be desirable to model American
calls more precisely and is exploring how they might be precisely, but
efficiently, modeled or whether a more appropriate simplifying
assumption should be used. For now, the final rule continues to treat
American-style calls as Bermudan-style calls.
In addition to the change made in response to the comments, OFHEO
restructured the Appendix sections dealing with cash flows produced by
nonmortgage instruments by combining the section of NPR2 dealing with
debt with the section dealing with nonmortgage investment and
investment-linked derivative contracts. OFHEO notes that this
restructuring permits OFHEO to use a single modeling instruction for
two types of instruments that have identical cash flows. That is, a
fixed rate noncallable bond has the same cash flows whether it is
modeled as a liability or an asset; the only difference is the party
that receives the cash flow. The final rule also deletes instructions
for specific types of instruments where more general provisions in the
Appendix are sufficient to generate the necessary cash flows according
to the terms of the instrument. In some cases, simplifying assumptions
are made for certain instrument terms. These modifications serve to
streamline the regulation.
While the final rule replaces specific modeling instructions with
more general ones, the general instructions are more detailed in some
respects than those proposed in NPR2. For example, the final rule
specifies more detailed treatment of the options on nonmortgage
instruments and cancellation rules on interest rate swaps.\160\
Although NPR2 did not specifically mention call premiums and discounts,
the final regulation specifies the manner in which the premiums and
discounts for certain instruments are modeled. In addition, because the
Enterprises use some interest-rate swaps to reduce the interest-rate
risk associated with some callable debt they issue, OFHEO has decided
to model put options associated with swaps so that those putable swaps
are cancelled when the associated debt is called. Puts on Enterprise
debt and calls on nonmortgage assets are still not modeled, given that
would entail modeling the behavior of a third party that can exercise
the option rather than the behavior of an Enterprise.
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\160\ An interest rate swap is an agreement whereby two parties
(counterparties) agree to exchange periodic streams of interest
payments on obligations they have issued. The dollar amount of the
interest rate payments exchanged is based on a predetermined dollar
principal (often the face amount of the underlying instrument),
which is called the notional principal amount. The dollar amount
each counterparty pays to the other is the agreed-upon periodic
interest rate multiplied by the notional principal amount.
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In the final rule, the more detailed general descriptions for
noncomplex instruments are sufficient to provide an understanding of
how each instrument is modeled. For some complex instruments, as with
the description of the noncomplex instruments, industry standard
methodology is used. In addition, the computer code that OFHEO plans to
release after the rule is published will provide detail on the
algorithms used.
N. Accounting, Taxes, and Operating Expenses
In NPR2, OFHEO proposed procedures for creating pro forma balance
sheets and income statements, determining short-term debt issuance and
short-term investments, calculating operating expenses and taxes, and
computing capital distributions. The proposal explained the inputs and
outputs for this component of the stress test. Inputs included an
Enterprise's balance sheet at the beginning of the stress period,
interest rates from the interest rates section, and information from
the cash flow section. These inputs were used to produce as the output,
the 120 monthly pro forma balance sheets and income statements for an
Enterprise.
MBA, Fannie Mae and Freddie Mac commented on the proposed
approaches related to taxes and accounting. Among the specific issues
they raised were (1) the effective tax rate, (2) the adherence to
generally accepted accounting principles (GAAP), (3) the treatment of
non-interest earning assets, and (4) net operating losses. Several
commenters, in addition to the Enterprises, commented on the proposed
treatment of operating expenses. These comments and OFHEO's analysis of
the comments are discussed below.
1. Effective Tax Rate
In NPR2, OFHEO proposed \161\ to apply an effective Federal income
tax rate of 30 percent when calculating the monthly provision for
income taxes in the stress test. OFHEO noted that this tax rate is
lower than the statutory rate set forth by the Internal Revenue
Service. The Enterprises' lower overall tax rates are a result of tax
exempt interest, tax deductions for dividends, and equity investments
in affordable housing projects. OFHEO further noted that it may change
the 30 percent income tax rate if the Enterprises' effective tax rate
changes significantly over time or if the statutory income tax rate
changes.
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\161\ 64 FR 18297, April 13, 1999.
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Fannie Mae was the only commenter to address the proposal to
specify in the regulation a Federal effective income tax rate of 30
percent. Fannie Mae noted that this rate is lower than the current 35
percent corporate statutory rate because of the Enterprises'
involvement in tax-advantaged activities, such as investing in tax-
exempt mortgage revenue bonds and tax credits for affordable housing
projects, but asserted that adopting a fixed tax rate would undermine
the stress test's ability to relate the capital requirements
dynamically to the evolving nature of the Enterprise's business.
Accordingly, Fannie Mae recommended that the rule apply an effective
tax rate based on recent experience, i.e., an effective tax rate equal
to the average annual rate for each Enterprise over the most recent
three calendar years.
OFHEO decided not to adopt Fannie Mae's recommendation. OFHEO has
reserved in the regulation the discretion to change the 30 percent
income tax rate if there are significant changes in Enterprise
experience or changes in the statutory income tax rate. OFHEO believes
that this addresses Fannie Mae's concern by allowing OFHEO the
flexibility to make any reasonable adjustments to the rule, based on
significant changes in circumstances.
[[Page 47786]]
Fannie Mae's suggested approach would not have resulted in a
significant increase in sensitivity to risk, but would have added
unnecessary complexity to the stress test. Accordingly, OFHEO has
adopted without modification the proposal in NPR2 with respect to the
effective income tax rate.
2. Consistency With GAAP
In NPR2, OFHEO proposed to apply Generally Accepted Accounting
Principles (GAAP) in the stress test to the extent that they are
applicable and feasible.\162\
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\162\ Section 3.10.3.6 of the NPR2 Regulation Appendix, 64 FR
18298-18299, April 13, 1999.
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Only the Enterprises addressed the proposed accounting approach.
Although Freddie Mac generally agreed that the stress test should apply
GAAP to the extent possible, it mentioned several accounting treatments
that it believed should be modified. Fannie Mae stated that the
proposed regulation does not adhere to GAAP uniformly in describing the
procedures to use to generate projected monthly financial statements.
Accordingly, Fannie Mae recommended that OFHEO adopt a more generalized
approach toward accounting methods that would establish basic
guidelines for projecting stress test performance. Notwithstanding
Fannie Mae's preference for a generalized approach, both Freddie Mac
and it specifically requested that the stress test recognize Financial
Accounting Standard (FAS) 115 \163\ and FAS 133,\164\ both of which
require a portion of unrealized market value gains or losses on the
balance sheet to be recorded in a new stockholder's equity account
known as ``other comprehensive income'' (OCI).
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\163\ Financial Accounting Standards Board Statement of
Financial Accounting Standard 115, Accounting for Certain
Investments in Debt and Equity Securities, May 1993.
\164\ Financial Accounting Standards Board Statement of
Financial Accounting Standard 113, Accounting for Derivative
Instruments and Hedging Activities, June 1998.
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OFHEO agrees with the Enterprises that, to the extent that GAAP is
applicable, the risk-based capital regulation should adhere to GAAP.
Accordingly, like the proposed rule, the final rule adopts accounting
rules that are generally consistent with GAAP, although, in certain
situations, complete adherence to GAAP is impractical given the
stylized nature of the stress test. In those situations, such as with
FAS 115 and FAS 133, the agency has determined that it is necessary to
implement simplified procedures to allow the efficient and practical
implementation of the stress test. For instance, it would be
impracticable and unreasonably speculative to make mark-to-market
adjustments over the ten-year stress test. Given the difficulties
inherent in calculating future market values during the stress test,
OFHEO has decided to recognize unrealized gains (losses) resulting from
FAS 115 and FAS 133 and related OCI at the outset of the stress test.
That is, the stress test does not reflect certain securities at their
fair market values later in the stress test, as required by FAS 115 and
FAS 133. Instead, these assets are adjusted to an amortized cost basis
at the outset of the stress test. Similarly, gains and losses resulting
from the termination of derivative instruments during the stress period
are amortized on a straight-line basis over the same period used to
calculate the gain or loss.
3. Treatment of Non-Interest Earning Assets
In NPR2, OFHEO proposed to convert to cash non-earning assets, such
as miscellaneous receivables, real estate owned (REO), and general
clearing accounts, by the end of the stress test's first year. NPR2
allowed other non-earning assets, such as investments in low income
housing tax credits, to remain constant over the stress period, i.e.,
be carried over from quarter to quarter and earn no income.\165\
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\165\ 64 FR 18298, April 13, 1999.
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Three commenters stated that the treatment of non-interest earning
assets in the stress test would penalize investments in affordable
housing programs. Fannie Mae stated that investments in affordable
housing should be converted to cash over the first six months of the
stress period, thereby eliminating what it termed an ``artificial
burden'' to this type of investment. Freddie Mac stated that these
assets should be converted to cash when the Enterprises begin to show
net losses to reflect the resulting elimination of associated tax
benefits.
After reviewing the comments, OFHEO has decided to adopt the
proposed rule with one modification. Investments in low income housing
tax credits are converted to cash over the first six months of the
stress period.
4. Net Operating Losses
In NPR2,\166\ OFHEO proposed to have a Net Operating Loss (NOL)
carryback period of three years so that an NOL for a current month
would be ``carried back'' to offset taxes in any or all of the
preceding three calendar years. OFHEO explained that this offset of the
prior years' taxes results in a negative provision for income taxes for
the current month. A period of 15 years was proposed for carry
forwards.
---------------------------------------------------------------------------
\166\ 64 FR 18297, April 13, 1999.
---------------------------------------------------------------------------
MBA and Fannie Mae commented that the proposed three-year carry
back period and 15-year carry forward periods for NOL tax offsets are
no longer consistent with the current tax code. These commenters
requested that these periods be changed to reflect the recent
legislation which specifies periods of two and twenty years,
respectively.
OFHEO has decided to modify the NOL carryback and carryforward
periods to two and twenty years, respectively. This will allow the
accounting procedures in the stress test to be consistent with the
current tax code.
5. Operating Expenses
In NPR2, OFHEO proposed that the stress test calculate operating
expenses, including those administrative expenses related to an
Enterprise's salaries and benefits, professional services, property,
equipment, and offices. Under the proposal, operating expenses would
decline in direct proportion to the decline in the volume of each
Enterprise's total mortgage portfolio (i.e., the sum of outstanding
principal balances of its retained and sold mortgage portfolios). The
stress test first projected how an Enterprise's mortgage portfolio
would change during the stress period on a monthly basis. It then
multiplied the percentage of assets remaining by one-third of the
Enterprise's operating expenses in the quarter immediately preceding
the start of the stress test to simulate the changed operating expenses
in each month of the stress period. The resulting amount would be an
Enterprise's operating expense for a given month in the stress period.
OFHEO explained that the expense reduction pattern for the up-rate
scenario would differ from the down-rate scenario, as would the pattern
within each scenario, depending on changes in the characteristics of an
Enterprise's total mortgage portfolio.
a. Comments
Commenters provided widely divergent views about the proposed
treatment of operating expenses. Among the issues that they addressed
were whether the proposed treatment would result in an appropriate
capital requirement, whether the stress test should link operating
expenses to the size of each Enterprise's mortgage portfolio, whether
the stress test should model fixed and variable expenses separately,
whether the stress test should exclude expenses associated with new
activities, and whether
[[Page 47787]]
operating expenses should be tied to the previous quarter's operating
expenses.
Commenters disagreed about the extent to which the proposed
treatment of operating expenses would result in an appropriate capital
requirement. The Enterprises and a Wall Street firm commented that the
proposal would result in an excessive capital requirement. Freddie Mac
stated that operating expenses constitute a relatively small portion of
its total expenses but a disproportionately large component of its
capital requirement under the proposal. In contrast, several trade
associations and financial organizations stated that it would be more
appropriate to model operating expenses in a manner that would result
in a higher capital requirement. These differing views, which are
discussed below, were reflected in specific recommendations for
revising the stress test's modeling of operating expenses.
Commenters, for instance, disagreed about whether the stress test
should link operating expenses to the change in the size of an
Enterprise's mortgage portfolio during the stress test. The Enterprises
stated that the stress test should not incorporate such a linkage,
which they believe distorts risks. They were especially concerned that
such a modeling approach would result in significantly different
treatment for operating expenses depending on the interest rate
scenario. Fannie Mae stated that the capital requirement in the up-rate
scenario could be as much as $2 billion higher than the down-rate
scenario. In contrast, other financial firms stated that operating
expenses should remain constant rather than decline during the stress
test. They noted that having operating expenses decline is inconsistent
with the experience of a financial institution facing stressful
conditions. They argued that such institutions typically experience an
increase in operating expenses during stressful periods since more
expenses are incurred to manage defaults and repossessed real estate.
Commenters also disagreed about whether fixed and variable expenses
should be modeled together or separately. Both Enterprises stated that
the stress test should model fixed and variable costs separately and
then apply a fixed expense ratio against the projected mortgage
portfolio balances. Under their recommended approach, the level of
operating expenses would not vary based on the level of such expenses
in the quarter preceding the stress test. Other commenters believed
that the stress test should not separately model fixed and variable
expenses, but rather should hold these expenses constant during the
stress period.
Both Enterprises commented that the stress test should not consider
expenses related to new business development, product innovation, and
research, given the 1992 Act's ``no new business'' requirement.\167\
Freddie Mac stated that under the no new business requirement, this
portion of its operating expenses would drop nearly to zero during the
stress period. Similarly, Fannie Mae stated that less than half of each
company's current cost structure is devoted to maintenance and support
of existing book-of-business balances.
---------------------------------------------------------------------------
\167\ 12 U.S.C. 4611(a)(3)(A) states that ``No other purchases
of mortgages shall be assumed'' under the current rule, except for
contractual commitments.
---------------------------------------------------------------------------
b. OFHEO's Response
As the widely divergent comments indicated, there is no single
``correct'' way to model operating expenses, particularly in a stylized
stress test which by necessity must incorporate simplifying
specifications. In general, the Enterprises stated that the proposed
treatment would result in unreasonably high capital requirements,
whereas other financial institutions stated that the proposed treatment
would result in unreasonably low capital requirements. OFHEO believes
that the recommendation by both Enterprises to have a fixed expense
ratio of between 1.5 and 2.0 basis points of unpaid principal balance
(UPB) per year is unreasonably low. As one commenter noted, Enterprise
expenses to outstanding MBS and portfolio balances have averaged over
7.0 basis points for the past ten years. Similarly, although there was
intuitive appeal to the recommendation by financial institutions to
hold the level of expenses constant throughout the stress period given
the experience of financial institutions under stress, adopting such an
approach here would have resulted in unreasonably high capital
requirements relative to operating expenses.
After considering all of the comments, OFHEO has decided to adopt
the NPR2 approach to operating expense, with some modification. In the
final rule, the baseline operating expense level is the same as in
NPR2, and operating expenses continue to decrease as the mortgage
portfolios decrease, but the method of determining the amount of the
decrease is modified. Rather than a strictly proportional decrease, the
amount of the decrease in each month of the stress period is determined
by calculating a base amount comprised of a fixed component and a
variable component. The fixed component is equal to one-third of the
baseline level and remains fixed throughout the stress period. The
variable component at the start of the stress test is equal to two-
thirds of baseline and declines in direct proportion to the decline in
the UPB of the combined retained and sold mortgage portfolios. This
base amount is further reduced by one-third, except that this further
reduction is phased in during the first 12 months of the stress test.
In determining its treatment of operating expenses, OFHEO was
careful to balance the competing concerns expressed by the commenters.
Financial institutions facing extremely stressful conditions generally
do experience an increase in operating expenses, and therefore the
proportional reduction in all expenses that was contained in NPR2 may
understate the expenses that would be expected under the conditions of
the stress test. Nevertheless, OFHEO believes that holding all
operating expenses constant, as suggested by some commenters, would
have overstated operating expenses and that some reduction is
appropriate over time, given the cessation of all new business in the
stress test.
On balance, OFHEO believes that the formula in the final rule
provides an overall expense experience that is consistent with the
stress period. The gradual phase-in during the first 12 months of the
stress period of the adjustment to the base amount reflects the fact
that operating expenses would not be likely to change dramatically in
the first few months of the stress period. At any given time, the
Enterprises have numerous commitments and obligations that affect
operating expenses, including those related to personnel and
technological innovation. Upon entering a stressful period, it would
take some time for an Enterprise to implement modifications associated
with these commitments and obligations. OFHEO has determined that it
would be inappropriate to adopt the Enterprises' recommendations to
exclude expenses related to new business development, product
innovation, and research. As discussed in NPR2,\168\ OFHEO determined
that it would be inconsistent with the 1992 Act and the overall purpose
of the stress test for the model to attempt to reflect decisions that
would be made by an Enterprise that was intentionally winding down its
operations. Nevertheless, the one-third reduction in expenses
incorporated in the final rule reflects that the
[[Page 47788]]
elimination of new business would result in some permanent reduction in
operating expenses.
---------------------------------------------------------------------------
\168\ 64 FR 18168-69, April 13, 1999.
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O. Dividends and Share Repurchases
The proposed stress test specifies in each quarter of the stress
period whether the Enterprise pays preferred and common stock
dividends, and, if so, how much. For preferred and common stock,
dividends are paid as long as an Enterprise meets the minimum capital
requirement before and after the payment of these dividends. For
preferred stock, the payments are based on the coupon rates of the
issues outstanding. For common stock, dividends are paid in the first
year of the stress period. The payments are based on the trend in
earnings. If earnings are increasing, the dividend payout rate is equal
to the average of the percentage payout of the preceding four quarters.
If earnings are not increasing, then the amount of dividends paid is
based on the preceding quarter's dollar amount of dividends per share.
If a full dividend would cause the Enterprise to fall below its
estimated minimum capital level, then a partial dividend is paid. The
proposed stress test did not recognize other capital distributions such
as repurchases of common stock or redemptions of preferred stock.
Fannie Mae and Freddie Mac were the only commenters on the proposed
treatment of dividends.
1. Preferred Stock
With regard to preferred stock, Freddie Mac agreed with the
proposal, stating that it appropriately differentiates between
preferred and common stock and appropriately captures distinctions in
the effects of different preferred stock structures on the extent to
which such equity capital is available to absorb losses. Fannie Mae
disagreed with the proposed treatment of preferred stock dividends,
stating that it would be inappropriate to assume that the Enterprises
would continue to pay preferred dividends and deplete capital reserves
throughout the stress period when they might be classified as
``undercapitalized.'' \169\ That Enterprise recommended that the stress
test terminate all capital distributions at the end of the first year
of the stress period.
---------------------------------------------------------------------------
\169\ Under the 1992 Act an Enterprise is undercapitalized if it
does not meet its risk-based capital requirement but meets the
minimum requirement, 12 U.S.C. 4614(a).
---------------------------------------------------------------------------
The final rule adopts the NPR2 treatment of preferred dividends
without change. After reviewing the comments on the payment of
preferred stock dividends during the stress period, OFHEO has
determined that it is appropriate for the stress test to distinguish
between the two types of equity and allow the payment of preferred
stock dividends in some circumstances in which common stock dividends
are not paid. Such a distinction reflects the higher level of
commitment that a corporation makes to investors when issuing preferred
stock versus common stock, since preferred stockholders have a first
claim on capital distributions.
2. Common Stock
With regard to common stock, both Enterprises agreed with the
proposal to cease paying dividends after the first year of the stress
test. They stated that such a treatment is appropriate and aligns
dividends with the capital classifications and real economic
incentives. Both Enterprises, however, offered recommendations to
modify the proposed dividend rate for common stock. Freddie Mac
recommended using a long-term industry average dividend rate specified
in the regulation that would be approximately 25 percent of earnings
rather than a rate based on dividend payments in recent quarters. That
Enterprise believed that such an approach would simplify the
regulation's operation by substituting a single fixed value for a
process that would require collecting data on four prior quarters of
dividend payments and earnings, calculating the payout ratio for each
quarter, and averaging those ratios. Fannie Mae stated that it is
inappropriate to rely on a one-year time frame in which payments could
be overly volatile, especially if there were a one-time distribution.
Fannie Mae recommended basing the payout rates on the most recent
three-year period, claiming such a change would reduce unnecessary
volatility in the capital requirement.
After analyzing the comments, OFHEO has determined that it is
appropriate to adopt the payout rates as proposed in NPR2. OFHEO notes
that between 1990 and 1999 Fannie Mae's dividend payout ratio ranged
from a low of 16 percent in 1990 to a high of 35 percent in 1995;
whereas, Freddie Mac's dividend payout ratio ranged from a low of 20
percent in 1994 to a high of 23 percent in 1990.
Given such wide ranges in dividend payouts by one of the
Enterprises, it would be inappropriate to adopt Freddie Mac's
recommendation to set by regulation a dividend payout ratio of 25
percent. OFHEO has also decided not to adopt Fannie Mae's
recommendation to extend the time period used to determine the payout
rate from one year to three years. While Fannie Mae is correct that its
recommended approach would reduce volatility in the capital
requirements, such an extended time period under the recommendation
would make it more difficult for the stress test to identify quickly
changing Enterprise dividend policy that might deplete an Enterprise's
capital. Tripling the time period on which the dividend rate is based
would be inconsistent with the need for the stress test to provide a
timely early warning of potential capital deficiencies.
Table 7.--Dividend Payout Ratio for Fannie Mae and Freddie Mac
----------------------------------------------------------------------------------------------------------------
Fannie Mae 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990
----------------------------------------------------------------------------------------------------------------
Common Stock Dividend........... 1.08 0.96 0.84 0.76 0.68 0.60 0.46 0.34 0.26 0.18
----------------------------------------------------------------------------------------------------------------
Diluted EPS..................... 3.72 3.23 2.83 2.48 1.95 1.94 1.71 1.48 1.25 1.12
----------------------------------------------------------------------------------------------------------------
Div. Payout Ratio............... 29% 30% 30% 31% 35% 31% 27% 23% 21% 16%
----------------------------------------------------------------------------------------------------------------
Freddie Mac 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990
----------------------------------------------------------------------------------------------------------------
Common Stock Dividend........... 0.60 0.48 0.40 0.35 0.30 0.26 0.22 0.19 0.17 0.13
----------------------------------------------------------------------------------------------------------------
Diluted EPS..................... 2.96 2.31 1.88 1.63 1.42 1.27 1.02 0.82 0.77 0.57
----------------------------------------------------------------------------------------------------------------
Div. Payout Ratio............... 20% 21% 21% 21% 21% 20% 22% 23% 22% 23%
----------------------------------------------------------------------------------------------------------------
[[Page 47789]]
3. Share Repurchases
In the only comment that addressed other types of capital
distributions, Freddie Mac recommended that the stress test count share
repurchases as common stock dividends because an Enterprise could
follow a strategy of making capital distributions either by dividends
or share repurchases. It stated that without this modification, an
Enterprise would have to hold more future capital if it made a capital
distribution solely by way of dividend payments than if it made an
identical distribution by way of share repurchases. Freddie Mac, while
acknowledging that reducing dividends is more difficult than ceasing
share repurchases, argued that such differential treatment is not
warranted by small differences in risk presented by these two forms of
capital distributions.
OFHEO has decided to include rules in the stress test addressing
share repurchases during the stress period. OFHEO agrees that share
repurchases are potentially significant capital distributions that
should be reflected in the stress test. However, unlike common stock
dividends that are paid for the first four quarters of the stress
period, the stress test provides for share repurchases only during the
first two quarters. OFHEO believes that this shorter period more
closely reflects what would likely occur as the Enterprise begins to
experience the adverse economic conditions of the stress test.
4. Oversight Responsibility
OFHEO emphasizes that there are significant differences between
establishing a modeling decision for dividend payments and share
repurchases in the risk-based capital regulation and acting on a
dividend approval request from an Enterprise that is no longer
adequately capitalized. Accordingly, provisions in the stress test that
provide for the payment of dividends by an undercapitalized Enterprise
in some circumstances and not others should not be interpreted as an
indication of how OFHEO will act on any specific dividend approval
request. Should the situation arise, OFHEO will evaluate any request
for approval of a dividend payment on the basis of a case-by-case
analysis of all the relevant facts and circumstances.
P. Capital Calculation
1. Background
In NPR2, OFHEO proposed procedures to calculate the amount of
capital that an Enterprise would need just to maintain positive capital
during the stress test. Under the proposal, once the stress test
projects an Enterprise's capital at the end of every month in the ten-
year stress period, the capital calculation process discounts the
monthly capital balances back to the start date of the stress period.
The Enterprise's starting capital is then adjusted by subtracting the
lowest of the discounted capital balances to account for the smallest
capital excess or largest deficit (i.e., subtracting a negative number
in the case of a deficit). The factor used to discount a monthly
capital balance is based on after-tax borrowing or investing yields as
appropriate for that month and all previous months during the stress
period. After the stress test ascertains the amount of capital
necessary to maintain positive capital during the stress period it then
multiplies the amount by an additional 30 percent to arrive at the
risk-based capital requirement. The additional 30 percent is mandated
by section 1361(c) of the 1992 Act to capture the management and
operations risk of an Enterprise.
OFHEO stated in NPR2 that it was necessary to use a present-value
approach to recognize that a dollar today is worth significantly more
than a dollar ten years in the future, that is, a dollar of capital at
the beginning of the stress period can be invested to return more in a
later year. NPR2 employed selected discount rates that approximate an
``iterative approach'' also discussed in NPR2. An iterative approach
would use a series of iterative simulations as it adjusted the
Enterprise's balance sheet until it determined a starting level of
capital necessary for an Enterprise just to maintain positive capital,
but no more, throughout the stress period. Both approaches take into
account the two different interest rate scenarios by applying different
interest rates in the capital calculation for each scenario. Both
approaches were designed to ensure that an Enterprise would have enough
capital to survive the stress test regardless of when losses associated
with management and operations risk might occur, even if that were the
first day of the stress period. However, OFHEO proposed the present
value approach because it is much simpler to design and replicate.
2. Comments
Fannie Mae and Freddie Mac were the only commenters to address the
proposed method to calculate the risk-based capital requirement. Each
Enterprise objected to the use of a present value approach. Instead,
they each recommended that the stress test should base the amount of
required risk-based capital solely on the maximum amount of total
capital consumed during the stress period, i.e., subtracting the lowest
stress-period capital level without discounting from the starting
position total capital. Fannie Mae criticized the present value
approach, claiming that it is contrary to the 1992 Act's ``directive''
to follow Generally Accepted Accounting Principles (GAAP), results in
inappropriate incentives, and is contrary to standard industry
practice. Freddie Mac stated that the present value approach distorts
the assessment of capital and risk and raises timing issues, based on
the assumption that management and operations risk is proportional to
the interest rate risk and credit risk. That Enterprise stated that the
proposed discounting method assumes that losses associated with
management and operations risk occur at the very beginning of the
stress test.
3. OFHEO's Response
The final regulation generally adopts the approach to calculating
risk-based capital proposed in NPR2.\170\ After reviewing the proposed
method of calculating risk-based capital in light of the comments,
OFHEO found the present value approach preferable to the approach
suggested by the Enterprises. By discounting, the present value
approach allows the capital calculation process to account for the time
value of money. The time value of money is important because the stress
period extends for ten years during which funds would be invested
constantly and during which management and operations losses could
occur at any time, including the beginning of the stress period.
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\170\ As discussed in the Regulation Appendix, certain
additional amounts relating to off-balance-sheet items addressed in
section 3.9, Alternative Modeling Treatments, are included in the
calculation of risk-based capital.
---------------------------------------------------------------------------
OFHEO disagrees with each of the commenters' criticisms of its use
of a present value approach. Specifically, OFHEO disagrees with the
Enterprises' claim that basing the amount of capital required for the
stress test on a capital consumption approach is more consistent with
the statute or more appropriate from a risk management perspective than
the discounting approach used by OFHEO. First, the approaches
recommended by the Enterprises would not ensure that the Enterprises
hold capital sufficient to survive the stress test if management and
operations losses occurred at the beginning of the ten-year stress
period; they would only provide such assurances if these losses
occurred near
[[Page 47790]]
the end of that period. Second, OFHEO believes that a present value
approach is appropriate because it requires an Enterprise to maintain a
capital cushion for other risks when credit risk and interest rate risk
are relatively low. Thus, an Enterprise is more likely to survive
subsequent, more stressful periods. Third, OFHEO finds no merit to the
claim that a present value approach is contrary to standard industry
practices; clearly, present value theory is well established in finance
and economics, both in academia and in industry. Fourth, in response to
Freddie Mac's comment, the present value approach requires an
Enterprise to have positive capital at any time during the ten-year
stress period, even if a loss attributable to management and operations
risk occurs at the beginning of the ten-year stress period.
IV. Regulatory Impact
A. Executive Order 12866--Economic Analysis
1. Introduction
This rule implements the statutory direction to OFHEO in the 1992
Act to set forth in a regulation a risk-based capital test that applies
prescribed credit and interest rate stresses to the Enterprises'
businesses. Recognizing the novelty of this type of regulation, OFHEO
issued a series of notices soliciting public comment. First, the ANPR
sought public comment on a number of issues relating to the development
of the regulation. These comments were considered in the development of
the two subsequent NPRs addressing different components of the risk-
based capital regulation. NPR1 related to the methodology for
identifying the benchmark loss experience and the use of OFHEO's House
Price Index in the stress test. NPR2 set forth the remaining
specifications of the stress test. In addition, OFHEO published a
Notice soliciting reply comments to provide interested parties an
opportunity to respond to other commenters. Throughout the preambles of
the NPRs and in OFHEO's responses to comment on the NPRs, OFHEO has
provided justification for all of the choices that have been made and
has explained the effects of those choices in the rulemaking. All
plausible models and assumptions that were suggested by commenters or
otherwise identified by OFHEO have been discussed in the rulemaking
documents.
This regulation has been reviewed by the Office of Management and
Budget (OMB) in accordance with Executive Order 12866, Regulatory
Planning and Review (E.O. 12866). OMB has determined that this is an
economically significant rule. OFHEO has conducted an economic analysis
of the final rule in accordance with the E.O. 12866 and has concluded
that there is adequate information indicating the need for the risk-
based capital regulation and that the potential benefits to the
Enterprises, the housing market, homeowners, and taxpayers, far exceed
any potential costs that may result from compliance with this rule.
In making this determination, OFHEO took into account that the rule
relies on performance objectives to the maximum extent possible in
helping to ensure the adequate capitalization of the Enterprises. In
addition, the economic analysis reveals that the decisions contained in
this rule were based upon the best reasonably obtainable technical,
economic, and other information germane to the subject matter of the
rule. OFHEO considered a reasonable number of alternatives for each of
these decisions and chose the most cost-effective alternative that
achieves the purposes of the 1992 Act. All plausible models and
assumptions that were suggested by commenters or otherwise identified
by OFHEO have been discussed in the rulemaking documents.
In conducting its analysis, OFHEO has been guided by the principles
of fair disclosure and transparency. In addition, the rule is
implemented in a manner that, to the extent possible, provides
transparency of the capital calculation process used by OFHEO, which
will benefit the Enterprises and other interested parties. OFHEO has
solicited comments on all aspects of the rule through the ANPR and two
NPRs described above. To assist commenters in evaluating the rule,
OFHEO provided technical information on its website, in addition to the
extensive material included with the notices.
2. Statement of Need for Proposed Action
The specificity of the statutory requirement to set forth a capital
stress test in a regulation reflects a Congressional determination that
there is a need for this regulation and that the benefits to be derived
exceed any potential costs involved. The 1992 Act specifies key
elements of that stress test, which is to be designed to identify the
amount of capital that an Enterprise must hold at any given time in
order to maintain positive capital for a ten-year period of economic
stress. OFHEO concurs with the Congressional judgment that such a
regulation is necessary in order to ensure that the Enterprises can
continue to fulfill their important public purposes and to reduce the
potential risk of the serious disruptions that could occur if one or
both of the Enterprises experienced economic difficulties.
The Enterprises perform an important role in the nation's housing
finance system. Issuances of debt and guaranteed mortgage-backed
securities by the Enterprises have grown enormously in the past decade,
providing more than half of the conventional financing of housing in
the United States. The Enterprises are the largest sources of secondary
mortgage market credit throughout the United States and fill a
particularly important role in providing assistance in the areas of
low- and moderate-income housing. Financial failure of an Enterprise
could result not only in losses to investors in its securities, but
also decreased public confidence in the securities of the other
Enterprise and of the Federal Home Loan Banks, which are also Federal
Government sponsored enterprises that provide a source of financing for
housing. Such a failure also could cause decreased availability and
increased cost of financing for persons seeking to purchase or
refinance housing in the United States. For these reasons, public
confidence in the financial health of the Enterprises will help to
promote overall stability in the housing market, benefiting all
homeowners and other participants in that market.
Although the current risk of an Enterprise failure is small, the
continued financial stability of the Enterprises cannot be taken for
granted. Over the past two decades, failures of financial institutions
have been commonplace, including more than 2900 banks and thrifts and a
number of securities firms. The risks associated with Fannie Mae and
Freddie Mac differ in some important ways from those associated with
banks, thrifts, and securities firms. However, Government sponsored
enterprises are not immune to failure. Fannie Mae encountered serious
financial difficulty in the early 1980s, recovering in large part
because of a fortuitous decline in interest rates, and the Farm Credit
System experienced serious problems later in the decade. Because of the
Enterprises' key role and important public mission, Congress created
OFHEO to ensure their safe and sound operation. The current combined
debt and guarantee obligations of the Enterprises amount to nearly $2.5
trillion, and, unlike banks, thrifts, and securities firms, no
Enterprise obligations are backed by an insurance fund that could
contribute toward meeting creditor claims.
[[Page 47791]]
The risk-based capital rule (in conjunction with OFHEO's other
regulatory tools) is intended to reduce the risk of financial failure
of an Enterprise. The rule can contribute to that goal by requiring the
Enterprises to hold more capital or take less risk than they otherwise
would in some or most circumstances, particularly those circumstances
in which the danger of failure is greatest. In circumstances in which
some capital or risk adjustment is necessary, the rule gives an
Enterprise the flexibility to choose whether more capital, less risk,
or a combination of the two best suits its business needs.
Capital reduces the risk of insolvency by absorbing losses. For
most firms, debt markets provide strong capital discipline, penalizing
a firm that is excessively leveraged with higher borrowing costs. That
discipline is largely lacking for the Enterprises because of their
status as Government sponsored enterprises. This lack of normal market
discipline is the type of significant ``market failure'' that is
described in the Office of Management and Budget (OMB) ``best
practices'' document (OMB Best Practices Guide).\171\ It makes capital
requirements particularly important for the Enterprises.
---------------------------------------------------------------------------
\171\ Economikc Analysis of Federal Regulations Under Executive
Order 12866. Office of Management and Budget (Undated document
representing the result of two-year study to describe the ``best
practices'' for preparing the economic analysis of a significant
action called for by E.O. 12866).
---------------------------------------------------------------------------
The statutory requirement to promulgate a risk-based capital
regulation reflects a Congressional judgment that the market failure
should be addressed through Government-mandated regulation. Enterprise
debt securities receive favorable pricing in the market, due in part to
the Enterprises' statutory Federal charters and advantages conferred
thereby and the perception that the Federal Government would act to
prevent an Enterprise's default. This perception, as well as the
Enterprises' dominant position in the secondary market for conventional
residential mortgage loans, lessens the market discipline that would
apply if the Enterprises were not Government-sponsored enterprises.
OFHEO views the Congressional direction to develop a risk-based capital
regulation as intended, in part, to compensate for this lack of market
discipline.
The market failure is significant, even though the Enterprises
currently are well managed and profitable, because, if the Enterprises
were to experience financial difficulties, disruptions could occur,
with significant adverse effects on the housing and financial markets.
Further, the market failure is significant because of the important
public purposes served by the Enterprises and the need to avoid the
expense to the taxpayer if intervention by the Federal Government were
found to be necessary.
In summary, OFHEO is confident that the risk-based capital rule
will perform effectively the role intended for it by the 1992 Act. It
will promote the Enterprises' safety and soundness, thereby enhancing
their ability to continue to carry out their public purposes.\172\
These purposes include providing stability in the secondary market for
residential mortgages and providing access to mortgage credit in
central cities, rural areas, and underserved areas.
---------------------------------------------------------------------------
\172\ 1992 Act, section 1302(2) (12 U.S.C. 4501(2)).
---------------------------------------------------------------------------
3. Examination of Alternative Approaches
a. Limitations Imposed by Statute
In developing the regulation, the Director of OFHEO (Director) has
discretion with respect to a number of issues related to the stress
test. However, the specificity of the 1992 Act provisions related to
the risk-based capital stress test defines a general level of
stringency and limits the alternative approaches available to OFHEO.
OFHEO is directed to: (1) Identify default and loss severity rates that
satisfy a specific statutory standard for credit stress (which OFHEO
has termed ``benchmark'' rates) and (2) apply a stress test that
subjects each Enterprise to a ten-year stress period with mortgage loss
rates that are reasonably related to these benchmark rates. Interest
rate shocks during the ten-year stress period are statutorily defined
as well. During the first year of the stress period the ten-year
constant maturity Treasury rate (CMT) must rise or fall by specified
amounts. In both scenarios (rising or falling rates), the rate must
remain constant for the remaining nine years of the stress period. The
risk-based capital requirement is based upon the scenario that requires
the higher capital amount at the beginning of the stress test for an
Enterprise to maintain positive capital throughout the stress period.
Although the 1992 Act defines a general level of required
stringency, OFHEO must make certain determinations reasonably related
to historical experience and certain determinations consistent with the
stress period. For example, the regulation must set forth the shape of
the Treasury yield curve during the ten-year period. The statute
provides that the curve should be reasonably related to historical
experience and otherwise judged reasonable by the Director. OFHEO also
has discretion to determine the levels of non-Treasury interest rates,
the rates of mortgage prepayments, dividend payments, and many other
factors, provided that they are consistent with the stress period. The
1992 Act also requires that the stress test be made public so that it
may be run by interested persons in the same manner as the Director.
This requirement, together with the need to apply the same stress test
to both Enterprises and the need to protect proprietary Enterprise data
from disclosure, imposed certain limitations on alternative approaches
that were available to implement the statute.
b. Use of Performance-Oriented Approach
The risk-based capital regulation, as anticipated by the 1992 Act,
is a performance-oriented standard. Rather than a uniform ratio-based
standard applied to both Enterprises without regard to their individual
risk profiles, the capital standards set by the regulation are specific
to each Enterprise's particular risk profile. The stress test takes
into account the risk characteristics of the particular assets and
liabilities and off-balance sheet obligations of each Enterprise and
predicts how these specific instruments will perform under stress.
Because the stress test models the entire existing business of an
Enterprise, and takes into account the actions the Enterprise has taken
to offset risk, there are numerous options (other than adjusting the
amount of total capital it holds) for an Enterprise to satisfy the
requirements of the regulation. To the extent that an Enterprise uses
these other options to manage its risk, its capital requirement will be
lower than it otherwise would be.
c. Alternative Levels of Stringency
The 1992 Act defines the general level of stringency of the risk-
based capital regulation by requiring the Enterprises to have enough
capital to survive statutorily prescribed stress conditions for a
period of ten years, plus an additional 30 percent for management and
operations risk. Stress conditions this severe have not been
experienced nationally for a comparable period of time since the Great
Depression. Within these parameters, certain decisions left to the
Director's discretion affect the relative stringency of the stress
test. These include decision rules for modeling credit enhancements and
[[Page 47792]]
derivatives (including how to take counterparty risk into account), the
payment of dividends, operating expenses, the issuance of debt and the
investment of excess funds, rates of prepayment (which are affected by
property valuation assumptions), and how to calculate the capital
needed to survive the ten-year stress period.
In developing these decision rules, OFHEO exercised its discretion
in a manner that it deemed consistent with the stress conditions
mandated by the 1992 Act. That is, OFHEO specified other stress test
conditions that were consistent with the stringency of the conditions
specified in the statute. In the yield curve specification, for
example, OFHEO could have chosen yield curves that would have had the
effect of either greatly mitigating or exacerbating the most likely
economic impact of the statutorily imposed shocks to the ten-year rate.
Instead, OFHEO selected curves in both scenarios that did not, in
OFHEO's judgment, have either effect.
In general, OFHEO modeled instruments according to their terms, in
order to reflect accurately their performance under the conditions of
the stress period. In the few instances where, because of the
unavailability of data or satisfactory modeling techniques, it was not
possible to model instruments in this way, OFHEO employed conservative
measures, which have the effect of discouraging large volumes of
activities the risk of which could not be quantified with some
precision in the stress test. It follows, therefore, that the more
precisely instruments and activities can be modeled, the lower the
amount of capital that generally will be required. However, precise
modeling requires adequate data and careful research. Therefore, the
rule is structured to encourage the Enterprises to maintain and deliver
good data, which will allow OFHEO to provide accurate and timely
assessments of the risks of all Enterprise business activities.
d. Alternative Effective Dates
The 1992 Act provides that the regulation shall take effect upon
issuance, but provides a one-year period from the effective date before
the supervisory authorities that are tied to the risk-based capital
level take effect.\173\ These provisions override the Administrative
Procedure Act (APA) requirement for a 30-day delayed effective date for
substantive rules \174\ and do not give the Director discretion to
alter the timetable. However, a subsequent Congressional enactment, the
Small Business Regulatory Enforcement Fairness Act (SBREFA), delays the
effective date for rules that OMB has determined to be ``major rules''
for at least 60 days from the date they are submitted to Congress for
review or the date of publication, whichever is later.\175\
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\173\ 12 U.S.C. 4611(e)(1), 4614(d), 4615(c).
\174\ 5 U.S.C. 553(d).
\175\ If a joint resolution of disapproval is passed by Congress
during the 60-day period, the rule may be further delayed if the
President does not sign the joint resolution of disapproval. 5
U.S.C. 801(a)(3).
---------------------------------------------------------------------------
OFHEO believes that the language in the two statutes can be
harmonized by regarding the one-year transition period in the 1992 Act
as a de facto delayed effectiveness date that runs concurrently with
the 60-day delay required by SBREFA. In any event, SBREFA provides a
good cause exception to the 60-day delayed effective date, which OFHEO
has determined is appropriate to this rule. Because the 1992 Act
already provides a one-year delay in enforcement of the regulation,
during which Congress could act to overturn the rule if it chose, no
further purpose would be served by adding on to that period the
additional 60 days from SBREFA.\176\ The requirement in the 1992 Act
that the regulation become effective immediately reflects a
Congressional determination, with which OFHEO agrees, that the public
interest in safe and sound Enterprises is best served by implementing
the rule without delay. The effect of an additional 60-day delay in the
effective date would be to prevent OFHEO from using certain of its
prompt corrective action authorities to deal with a deficiency in risk-
based capital until 14 months after publication of the rule. Given that
Congress has determined that 12 months is sufficient time for the
Enterprises to adapt to the rule, the public interest would not be
served by extending that period. On the contrary, it would not be in
the public interest to further delay the effective date of prompt
corrective action authorities for longer than the one-year period
specified in the 1992 Act. In short, OFHEO believes the Congress has
provided an ample phase-in period for the implementation of this
regulation and that further delay increases financial risk with no off-
setting benefit to the general public or the Congress. It should be
noted, however, that, after the end of this phase-in period, OFHEO has
considerable discretion in its supervisory responses, depending upon
the circumstances, in the event of a risk-based capital shortfall.
---------------------------------------------------------------------------
\176\ Provisions in the Enterprises' respective charter acts
that limit capital distributions without the approval of the
Director if an Enterprise does not meet its risk-based capital
requirement do not include the one-year delay specified in the 1992
Act. However, OFHEO does not intend that the risk-based capital rule
will require approval of ordinary-course dividend payments, share
repurchases and redemptions that an Enterprise makes during the
transition year. During that period, the rule would have no impact
on an Enterprise's ability to make capital distributions absent
adequate notice to the Enterprise of its capital position and
adequate opportunity to take reasonable and prudent steps to address
any articulated deficiency. See, supra, section III.B.6.,
Interaction with Charter Act Provisions. In any event, if an
Enterprise fell short of its risk-based capital requirement during
the first year after the rule's effective date, OFHEO would not
withhold approval of capital distributions without careful
consideration of the circumstances of the shortfall. These factors
could include the causes of the shortfall and the likelihood it
would soon be eliminated (or had already been eliminated).
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e. Alternative Methods of Ensuring Compliance
Alternative methods of compliance with reporting provisions were
considered. Feeds of raw data from the Enterprises, which would be
processed by OFHEO, were originally thought to be the least burdensome
option, but ultimately were found by the Enterprises and OFHEO to be
problematic. The Enterprises commented that the data normalization
performed by OFHEO to ensure that comparable data was captured for both
Enterprises resulted in data translation errors. They expressed concern
that resolving these errors would consume so much time after the data
was submitted that accurate capital classifications could not be
produced with sufficient timeliness to be useful as a regulatory tool
or useful to the Enterprises in their planning. The Enterprises
suggested instead that they be allowed to process their data and run a
stress test specified by OFHEO using their own internal systems. They
would provide OFHEO with the capital numbers, which would be
presumptively final, unless OFHEO found an error.
For reasons discussed in section III.A.2., Proprietary/Internal
Models, OFHEO did not agree that presumptive finality should be
accorded to the Enterprises' calculations of their risk-based capital
requirements. However, OFHEO agreed that allowing the Enterprises to
process most of the data required to run the stress test using their
internal systems and to submit a report with the data appropriately
aggregated in the standardized format specified by OFHEO (along with
the raw loan data used in preparing the report) would eliminate the
data normalization step and allow quicker capital classifications. The
final rule, therefore, requires the Enterprises to submit a
[[Page 47793]]
Risk-Based Capital Report that contains the data required to run the
stress test, aggregated by the Enterprises according to the stress test
rules of aggregation specified by OFHEO. The stress test will be run by
OFHEO using model-ready inputs submitted in the Risk-Based Capital
Report. The accuracy and completeness of the Report, along with the raw
data from which the Report is prepared, must be certified by the
Enterprise official with responsibility for capital adequacy. The
preparation of the Report, including the aggregation of data in a
model-ready format, is subject to OFHEO's supervision and oversight,
and appropriate penalties are available for false certification.
Methods of ensuring compliance with the substantive requirements of
the rule--that is, ensuring that the Enterprises maintain adequate
risk-based capital as determined under the rule--are largely prescribed
by statute, based on the capital classification of the Enterprise. The
1992 Act requires that these classifications be determined at least
quarterly and reported to the Congress annually. The Act provides OFHEO
discretion to make more frequent capital determinations, but the
alternative of substituting less frequent, random classifications,
which is suggested in the OMB Best Practices Guide, is not an option
under the statute. OFHEO does not presently find a need to specify by
regulation the circumstances under which it might make determinations
of capital classifications more frequently than quarterly. However, low
capital levels, high risk activities, inadequacies in risk management
techniques, or various adverse events external to the Enterprises are
the types of concerns that could make more frequent capital
classifications prudent.
The risk-based capital rule sets the standard and the procedure for
determining whether an Enterprise is undercapitalized, but does not
impose a specific sanction or remedial measure in the event of
noncompliance. Those sanctions or other measures are not a subject of
this rulemaking. OFHEO notes, however, that, under the 1992 Act, if an
Enterprise fails to meet its applicable capital standard, it must
submit a capital restoration plan for the approval of the Director. In
addition, the Enterprise becomes subject to restrictions on capital
distributions, only some of which may be waived or modified by the
Director. Also, depending upon the severity of the undercapitalization,
other enforcement tools are provided, some of which are mandatory.
f. Informational Measures
Executive Order 12866 contemplates that agencies should consider
voluntary public disclosure systems as an alternative to other types of
regulatory mechanisms. The 1992 Act does not allow for OFHEO to
substitute such a voluntary system of financial disclosure for the
mandatory risk-based capital determination. However, OFHEO agrees with
the general implication in E.O. 12866 that financial disclosure
enhances market discipline, and has chosen to publish its capital
classifications of the Enterprises, together with their total and core
capital levels and their respective risk-based, minimum, and critical
capital requirements. Because the Enterprises' risk-based capital
levels reflect the results of the stress test, and because the
operation of the stress test is transparent to the public, OFHEO views
the risk-based capital rule as an important step in providing greater
public disclosure of financial risk at the Enterprises. Also, OFHEO is
currently considering the extent to which disclosure of other financial
data about the Enterprises may serve to improve market discipline
without compromising information that, for legal or public-policy
reasons, should remain non-public.
Given the legal structure of the Enterprises and their dominant
position in the secondary market for conventional residential mortgage
loans, there are also practical limits to the extent to which
informational measures alone can provide sufficient market discipline
to ensure their safety and soundness. The need for OFHEO and the other
regulatory structures put in place by the 1992 Act arose in large part
from the public perception that the Federal Government would intervene
to prevent default by either of the Enterprises or by other Government-
sponsored enterprises. Accordingly, Congress has made the determination
that market discipline alone will be insufficient to prevent or serve
as an early warning of Enterprise failure. To avoid the potential costs
and disruptions that could occur in the event of the financial failure
of an Enterprise, the 1992 Act established a regulatory system with
sufficiently stringent capital requirements to prevent the insolvency
of the Enterprises under extreme financial conditions. The risk-based
capital regulation is a mandatory aspect of that system.
g. Market-Oriented Approaches
Within the bounds of the 1992 Act, OFHEO has chosen the most
market-oriented alternative available. By requiring OFHEO to base
capital upon a stress test that takes into consideration both interest
rate and credit risk, the 1992 Act contemplates a rule that will
provide great flexibility to the Enterprises to determine the most
cost-effective means to match capital to risk. OFHEO has maximized the
market orientation of the statute in the regulation by using models
that make risk-based distinctions between many characteristics of the
thousands of different instruments, programs and activities of the
Enterprises. Because the risk-based capital rule is sensitive to these
distinctions, it gives the Enterprises a broad array of options in the
market--including altering the risk characteristics of their assets and
liabilities, using different hedging strategies, and raising capital--
to maintain compliance.
OFHEO has compared its risk-based capital regulation to the risk-
based capital systems in use by other Federal financial institution
regulatory agencies and has found that OFHEO's is the most market-
oriented approach. In particular, the system in use by bank and thrift
regulators, which is essentially a set of leverage ratios that are
assessed against relatively broad categories of instruments, provides
the regulated entities relatively few compliance options in the
marketplace. Although a financial institution may adjust its portfolio
to hold relatively fewer risky assets, these ratios do not take into
account many risk-mitigating actions that an institution might take to
hedge its risk.\177\ Further, the 1992 Act already specifies separate
leverage ratios in the form of minimum and critical capital levels,
which OFHEO has implemented in its minimum capital regulation. Other
systems in use for assessing financial institution risk, such as value-
at-risk models, are designed to serve more limited purposes (such as
assessing risk in a trading portfolio) and are inappropriate to
determine capital for an entire financial institution involved in
diverse business activities and are inconsistent with the statutory
mandate for a stress test. For these reasons, OFHEO concluded that its
risk-based capital rule utilizes the most market-oriented approach
reasonably available
[[Page 47794]]
to determine risk-based capital for the Enterprises.
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\177\ The recent Basel proposal is more risk-sensitive than the
current capital regime. It would provide for more consideration of
credit risk hedges, although the credit risk part of the proposal is
ratio-based. Committee on Banking Supervision, ``A New Capital
Adequacy Framework,'' Bank for International Settlements, Basel,
Switzerland (June 1999). A copy of this document may be obtained
from the BIS website at http://www.bis.org.
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h. Considering Specific Statutory Requirements
When a statute establishes a specific regulatory requirement and
the agency has discretion to adopt a more stringent standard, E.O.
12866 provides that the agency should examine the benefits and costs of
any more stringent alternative the agency proposes as well as the
specific statutory requirement.
As explained above, OFHEO has proposed a standard that is
consistent with the stringency provided for in the 1992 Act. The 1992
Act requires OFHEO to specify those elements of the stress test that
are not specified or not specified fully in the Act, but in most cases,
the specification must be either reasonably related to historical
experience or consistent with the stress period. Within these statutory
guidelines, OFHEO has significant discretion to make decisions about
the assumptions and operation of the stress test. The specifications
for some of these elements of the stress test have the potential to
increase or decrease the overall stressfulness of the regulation. In
each such case, OFHEO has chosen specifications that are consistent
with the conditions of the stress period.
Yield curve specifications provide an example of a choice OFHEO
made that is consistent with the conditions of the stress period. Both
the flat yield curve in the up-rate scenario and the upward-sloping
curve in the down-rate scenario are within the range of yield curves
that have been experienced frequently. Some comments complained that
these curves can result in short-term interest rates receiving a
greater shock than long-term rates.\178\ However, as explained in
detail in the preamble to the final rule,\179\ OFHEO found that such a
result is most consistent with the changes in the ten-year rates, based
upon historical experience. That is, when interest rates have risen
precipitously in the past, yield curves have tended to flatten. When
they drop precipitously, yield curves tend to steepen. Similarly,
although yield curves never actually maintain a static slope over time,
OFHEO found that maintaining a constant slope was most consistent with
the 1992 Act's specification of a constant ten-year CMT and was the
approach that best reflected the level of stringency intended in the
statute.
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\178\ If the yield curve is upward sloping prior to the
beginning of the stress test, short-term rates will move farther
than long term rates in the up-rate scenario, and less than long-
term rates in the down-rate scenario. If the yield curve is inverted
or downward sloping, the opposite effect will occur.
\179\ Section III.G.2.a., Specification of the Flat Yield Curve
in the Up-Rate Scenario.
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4. Analysis of Costs and Benefits
a. Introduction
Executive Order 12866 provides that the issuing agency will
establish a baseline against which the agency should measure a rule's
resulting costs and benefits, including those that can be monetized and
those that cannot. The agency must then explain how it weighed these
costs and benefits in reaching its decision on the regulation. The
Executive Order recognizes that in many cases the agency is required by
statute to act notwithstanding the outcome of this cost-benefit
analysis, but asks that it be performed nevertheless, so that the
impact of the regulation can be understood and to show that the costs
and benefits of any options that were available to the agency under the
statute were weighed appropriately.
Executive Order 12866 also contemplates that, if a regulation is
composed of a number of distinct provisions, the benefits and costs of
these different provisions will be evaluated separately. The preambles
to the final rule and the proposed rules break down the rule into such
distinct provisions and detail the decision-making in each. These
decisions typically were made after weighing the delays and costs of
more precise modeling against the likely impact of that greater degree
of precision on modeling. Because the number of decisions is large and
the interaction effects of these decisions are extensive, it is
impractical to analyze all possible combinations of possible decisions
as to every provision in the rule. Therefore, only those provisions
that OFHEO has found to be most significant or controversial have been
targeted for analysis in this economic analysis.
b. Baseline
Because the risk-based capital regulation is mandated by Congress,
OFHEO was faced with two choices for determining a baseline from which
to measure costs and benefits of the regulation. OFHEO could either use
a baseline scenario that assumes that the statutory requirement was
absent, or a baseline that assumes that the statutory requirement is
present but no regulation is adopted. For the purpose of this analysis,
OFHEO chose the latter.
The Enterprises have stated publicly that they support the stress
test that is embodied in the 1992 Act and implemented by the rule and
that they would apply a stress test and maintain capital in compliance
with the 1992 Act voluntarily in the absence of a rule. The baseline
scenario assumes, therefore, that each Enterprise constructs a stress
test, determines its risk-based capital requirement, and submits the
information to OFHEO quarterly. However, these voluntary numbers, which
are not produced pursuant to a risk-based capital rule, could not form
the basis for the Enterprises' capital classifications. The 1992 Act
requires that until one year after OFHEO publishes its risk-based
capital regulation, OFHEO must base the capital classifications upon
the minimum and critical capital levels only.\180\ Consequently,
capital classification and supervisory actions related to capital
classifications would continue to be based on the minimum and critical
capital requirements. The baseline scenario also assumes that, although
no standardized risk-based capital data submission would be required,
the same types of information would be made available to OFHEO for the
purpose of its examination and supervisory responsibilities, including
examining the stress tests constructed by the Enterprises and the
accuracy of the internal capital requirements produced thereby.
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\180\ 12 U.S.C. 4614(d).
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c. Benefits of the Rule
The benefits of the final rule over the baseline scenario are
numerous. They accrue to the Federal Government (and hence taxpayers),
the Enterprises, homeowners, and capital market participants. The most
obvious and important of these benefits to all four groups is a reduced
risk of failure of the Enterprises. The Enterprises have a dominant
position in the secondary mortgage market and are a major presence in
the debt markets. Were either Enterprise to fail, the disruption to the
housing and financial markets likely would be significant. It could
affect the cost of financing for housing and the availability of new
housing, particularly affordable housing. The regulation will reduce
the risk of failure by providing objective, conservative, and
consistent standards for capital at the Enterprises. It will provide
maximum transparency, create greater comparability with the capital
requirements for other financial institutions, and allow OFHEO to
respond quickly to capital weakness at an Enterprise.
The economic distress of Fannie Mae in the 1979-1985 period was
significant and the 1992 Act was, in part, a response to Congressional
concern that,
[[Page 47795]]
but for a fortuitous change in interest rates, Fannie Mae might have
collapsed, costing investors or the Government billions of dollars.
Because of the growth of the Enterprises, a failure today could result
in much greater loss. Depending on the response of the Government to
such a failure, significant disruption to the financial and housing
markets, significant burdens on taxpayers, or both would result. The
losses resulting from the savings and loan crisis in the late 1980s,
which ultimately were borne by the U.S. taxpayer, are estimated at more
than $100 billion. However, the Enterprises have considerably more
dollar exposure than the entire savings and loan industry had in 1986.
Also, because of the central role of the Enterprises in the affordable
housing market, an Enterprise failure could have adverse impacts on the
availability and affordability of housing in many areas of the United
States.
The regulation has another important public benefit. A capital
standard is likely to be more conservative if it is determined
objectively and consistently for both Enterprises in a transparent and
evenhanded way by an agency of the Government responsible for their
safe and sound operation than if it is determined voluntarily by each
Enterprise. The Enterprises, by virtue of their structure, have far
less incentive than OFHEO to make conservative choices in the
construction of the stress test. They, like other privately owned
financial institutions, are subject to shareholder pressure to increase
earnings per share. In the absence of substantial market discipline
(based on fear of insolvency), a simple way to increase earnings per
share is to increase capital leverage, which reduces capital ratios. In
addition, non-compliance with the risk-based capital rule subjects an
Enterprise to statutory restrictions on capital distributions and to
special supervisory measures that could be imposed by OFHEO. Further,
in the baseline scenario, the capital requirement for each Enterprise
would be determined by a model tailored to that Enterprise's business
mix and methods, and there would be no comparability between the two
capital standards even if the risk profiles were the same. In sum,
shareholder pressures, competitive pressures, and the lack of a binding
regulation would likely result in weak and inconsistently applied
standards.
Government involvement in and approval of capital standards is
essential to create public confidence that they are appropriately
stringent, transparent, and fair. Government oversight and enforcement
also foster public confidence that the Enterprises are complying with
those standards. It is significant that, at least in the United States,
Federal regulators determine the required capital levels for all
federally regulated depository institutions. Given the sensitivity of
econometric models to changes or variations in the economic analyses
and assumptions that underlie them, the public would be appropriately
skeptical of a system of risk-based capital standards based on stress
tests designed, run, and monitored by the Enterprises themselves.
Further, although OFHEO's risk-based capital regulation falls
within that class of regulations that the agency is required to issue
notwithstanding the findings of the cost-benefit analysis, no
commenters urged OFHEO to support a statutory change to allow self-
regulation or eliminate the requirement for risk-based capital rules
for the Enterprises. Rather, commenters generally agreed that well
defined and stringent capital standards are important to ensuring the
safety and soundness of the Enterprises. Moreover, as explained below,
the costs of an effective risk-based capital rule are small relative to
its significant and apparent public benefits.
A unique benefit of OFHEO's risk-based capital rule is its
sensitivity to the credit and interest rate risk in each Enterprise's
business. The marginal capital associated with the assets, liabilities
and off-balance-sheet instruments of the Enterprises varies, not only
based upon the characteristics of the particular instrument, but also
based upon the mix of instruments in each Enterprise's portfolio.\181\
The stress test also takes into account the economic conditions as of
the date for which the stress test is run. For example, if housing
prices have been rising prior to the as-of date, a given portfolio of
seasoned loans will have a lower credit loss experience than if prices
have been declining, all other factors held equal. Likewise, current
interest rates may have a significant impact on the amount of capital
required of an Enterprise, depending upon how well hedged the
Enterprise is against interest rate risk.
---------------------------------------------------------------------------
\181\ See NPR2 section II.B Sensitivity of Capital Requirement
to Risk, 64 FR 18097 (April 13, 1999).
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The existence of a rule that complies with the statutory mandate
for notice and comment and replicability will create greater
transparency and promote more market discipline than a voluntary
system. Further, because OFHEO will design and run the stress test,
OFHEO may be able to act more quickly to deal with capital inadequacies
that may arise. Also, the rule is forward-looking, which helps ensure
that capital is built up as stressful economic periods develop, before
losses occur. As a response to the regulation, OFHEO anticipates that
the Enterprises may choose to build up a capital cushion during
favorable economic conditions, when capital is inexpensive, to avoid
having to raise capital or hedge risk in other ways during tough
economic times. The Enterprises have, in fact, increased their capital
levels since 1993 in response to the 1992 Act and in anticipation of
OFHEO's capital rules. Another benefit of the rule is that it rewards
risk reduction by the Enterprises with a lower capital requirement,
providing appropriate incentives to the Enterprises to hedge risk.
The transparency of the stress test will improve the ability of
market participants to evaluate each Enterprise's risk profile, risk
management techniques, and capital adequacy. The existence of an
independent and objective evaluation of capital adequacy and the
knowledge that prompt supervisory action is available to correct
deficiencies are likely to inspire greater investor confidence, which
may lower the cost of debt and capital to the Enterprises. To the
extent that these savings are passed along to consumers, the regulation
may benefit homeowners with lower mortgage costs. To the extent they
are not passed along, shareholders will benefit, offsetting, in part,
any increase in capital costs. Most importantly, conservative,
objectively determined capital standards mean that the Enterprises are
more likely to be able to continue to perform their important public
purposes, such as purchasing low- and moderate-income residential
mortgage loans.
d. Costs of the Rule
OFHEO has also considered whether there are certain costs, tangible
and intangible, associated with the regulation--that is, with a system
of mandatory rather than voluntary compliance. First, there will be a
reporting cost to the Enterprises. As a result of the need to report
data in a standardized format there may an initial cost associated with
the need to adapt existing computer systems to accommodate the periodic
reporting within the regulatory time frames. However, these costs have
largely been incurred already as OFHEO has worked with the Enterprises
to obtain the data necessary to design and run the stress test.
[[Page 47796]]
There will be personnel costs to the Enterprises associated with
preparation and certification of the quarterly data submissions.
However, similar reporting would be required of the Enterprises even in
the absence of the risk-based capital regulation, because OFHEO would
need much the same data in order to monitor closely the Enterprises'
internal modeling of the stress test and to support OFHEO's research
and analysis functions. Therefore, there is no certainty that reporting
costs to the Enterprises under the regulation will be significantly
higher than under the baseline scenario. Further, any possible cost
savings to the Enterprises in the baseline approach would be offset by
an increase in OFHEO examination time. This increase would occur
because, in the absence of a risk-based capital regulation, OFHEO would
need to spend considerably more examination resources than are
currently budgeted to validate the computer models (including the
databases upon which the models are estimated and operated) that the
Enterprises construct to run their internal stress tests. Examination
of the Enterprises' computer models will continue to be an important
aspect of OFHEO's functions after the risk-based capital rule is
implemented. However, if risk-based capital were to be determined based
upon the output of a single internal model at each Enterprise, that
model would require far more intense scrutiny than other business
models. Further, OFHEO would still need to maintain its internal
modeling capability in order to perform its research and analysis
functions under the 1992 Act. The net result would be considerably more
expense for OFHEO than the approach in the regulation.
It has been argued that under the voluntary system, the Enterprises
might be freer to modify many aspects of the stress test as soon as new
data become available, because they would not have to wait for a
regulator to determine capital treatments as their businesses change.
If this were true, it might allow them to align their capital with risk
more quickly than under the regulation. OFHEO views this benefit of a
voluntary system as speculative, at best. OFHEO would require
sufficient internal controls at the Enterprises to insure that
treatments of new activities were appropriately conservative and
capital calculations accurate. Moreover, OFHEO has streamlined its
procedures to deal with new activities and other modeling issues that
arise in order to provide prompt decisions on appropriate treatments.
It is not clear that internal systems at both Enterprises that are
designed to do the same thing would be less expensive or time-
consuming. It is clear, however, that the determinations made under
such internal systems would lack the transparency of similar
determinations made by OFHEO. It is also likely that the financial
markets would have greater confidence in the objectivity and fairness
of decisions of a Federal regulatory agency than in the internal
decisions of the Enterprises. Greater confidence in the capital numbers
could well reduce the overall cost of debt and capital to the
Enterprises.
Each Enterprise could argue that its allocation of capital cost to
various individual financial instruments would likely be different
under a voluntary system, but each Enterprise allocates capital costs
differently and bases those allocations upon numerous business
considerations in addition to the capital regulations. OFHEO has found
no basis for concluding that the rule would cause the Enterprises to
change their internal capital allocations to impose any material
additional cost on the various housing programs that comprise a primary
mission of the Enterprises. Further, OFHEO has found that the capital
requirements in the rule will not increase the cost of housing
generally or create other costs to the housing market or the larger
economy.
e. Costs and Benefits of Alternatives
The stress test contains many components and OFHEO considered
numerous means to design and implement each of them. As explained in
section IV.A.1., Introduction, the various combinations of these
alternatives are so numerous that it would be impractical to discuss
each possible combination. The preambles to the proposals and final
rule examine the alternatives related to each individual decision
discretely, and the preamble to the final rule analyzes the overall
result for reasonableness and compliance with statutory intent. In
addition, in the economic analysis below, OFHEO highlights selected
issues that could have a significant impact on the amount of capital
that an Enterprise might be required to hold and discusses the various
alternatives considered as to these core issues.
(i) Determination of the Benchmark Loss Experience
A threshold issue in creating the stress test was determining the
rates of default and severity ``that occurred in contiguous areas of
the United States containing an aggregate of not less than 5 percent of
the total population of the United States that, for a period of not
less than 2 years, experienced the highest rates of default and
severity of mortgage losses * * *'' \182\ OFHEO considered numerous
alternative statistical methodologies to make this determination. These
included various methods for determining what constituted a
``contiguous area,'' different methods for measuring default and
severity rates, different potential databases that could be used in the
analysis, and different methods of averaging and weighting the data
from the two Enterprises.
---------------------------------------------------------------------------
\182\ 12 U.S.C. Sec. 4611(a)(1).
---------------------------------------------------------------------------
The 1992 Act provides no guidance to OFHEO as to how a ``contiguous
area'' should be defined. OFHEO decided to define the term to mean a
group of contiguous states. Under this definition each state in the
area must share a common border with another state in the area--the
states could not simply meet at a point. OFHEO considered using smaller
units, such as the first two or three numbers of zip codes. In general,
the smaller the unit that is used in the aggregation, the higher the
benchmark loss rate that would be determined. By connecting pockets of
severe losses with narrow parcels of land, OFHEO could have created an
area with much higher loss rates than the benchmark loss experience
that was identified in NPR1. However, commenters on the issue
unanimously supported the use of states as the smallest geographic
unit, and suggested that using smaller units would create computational
difficulties and likely result in an area that would look
``gerrymandered.'' OFHEO found that conducting analysis at a state
level is a common rating agency practice and was the most logical,
efficient and reasonable approach to construct a benchmark area. Larger
areas, such as Federal Home Loan Bank districts and Census Regions,
were considered, but because each of these areas was comprised of a
fixed group of states, they did not provide the same flexibility or
range of potential areas as OFHEO's approach. Accordingly, they were
less likely to identify an area of the country that had experienced
sufficiently stressful economic circumstances to be appropriate for the
stress test defined in the 1992 Act. OFHEO also considered a Freddie
Mac suggestion that would have altered the formula for selecting areas
for comparison to include a ``compactness'' requirement, but determined
that this suggestion was inappropriate and unworkable. OFHEO disagreed
with Freddie Mac that the proposed methodology did not result in
reasonably compact areas. Moreover,
[[Page 47797]]
Freddie Mac's suggestion would have imposed an additional requirement,
``compactness,'' that goes beyond what the 1992 Act specified and could
well preclude identification of an appropriately stressful credit
environment.
OFHEO also considered a number of options in deciding how to
determine what event would constitute a default and how to measure the
severity of a loss for purposes of the benchmark analysis. OFHEO
considered including loans that had been subject to ``loss mitigation''
procedures (which ordinarily indicates that payments are not current on
a loan), in addition to loans that resulted in preforeclosure sales,
foreclosure, deed-in-lieu, or credit loss. OFHEO decided not to include
loss mitigation events as defaults, because data were not adequate to
identify them.
OFHEO considered whether to use loss severity rates in the
benchmark analysis with or without the effect of mortgage insurance or
other third-party credit enhancements taken into account. OFHEO
determined that the purposes of the 1992 Act were better served by
using loss severity rates without consideration of credit enhancements
in determining where and when mortgage losses were highest. The Act
requires OFHEO to identify the highest credit losses on mortgages, not
the highest net credit losses to the Enterprises. Further, this
methodology is more consistent with the stress test in the final rule,
which first calculates losses on mortgages and then determines the
extent to which those losses are reduced by credit enhancements.
OFHEO based the benchmark determination upon data on the
Enterprises' loans. OFHEO considered using other loan data, including
databases that were available on Federal Housing Administration loans
and credit bureau data. As explained in NPR1, OFHEO decided that the
Enterprises' loan data would be the most relevant source from which to
determine a benchmark loss experience for the Enterprises. The quality
and detail of those data are such that they reflect losses in recent
periods as well as or better than data from any other sources.
Moreover, using the Enterprises' data eliminates the problem of having
to sift out loans that would not be eligible for purchase by the
Enterprises or otherwise not be representative of the loans they
purchase.
Having determined that the Enterprises' loan data were the best
database for the analysis, OFHEO considered which group or groups of
loans from that database would be used to compare the many different
state/year combinations that meet the population and contiguity
requirements. The Enterprise loan data include information on loans of
many different types (fixed rate, adjustable rate, balloon, graduated
payment, second mortgages, etc.), supported by various types of
residential collateral (single-family detached homes, planned unit
developments, condominiums, multifamily buildings, two-to four-unit
homes, etc.). OFHEO considered which of these loan and collateral types
would be appropriate to include in an analysis of the worst loss
experience that met the statutory criteria. In order to have a common
loan type for comparison among potential benchmark periods and areas,
OFHEO limited its analysis to 30-year, single family, fixed-rate
mortgages. This group of loans was chosen because the Enterprises
historically have purchased large volumes of them and because they are
relatively homogenous, meaning their terms and conditions are
relatively uniform as compared to the other loan and collateral types.
OFHEO also considered whether to take the loan-to-value ratio (LTV)
of loans into account in determining the benchmark, because this ratio
is highly correlated with loan losses. A method of doing so, which
OFHEO considered, would determine loss rates by various LTV ranges and
then compute overall default or loss rates by assuming some standard
distribution of LTV ratios and weighting the LTV-specific loss rates
according to this distribution. OFHEO did not use either of these
alternative methodologies. Instead, OFHEO decided to compute loss rates
for candidate benchmark periods and areas on a dollar-weighted basis
only, without regard to LTV, for three reasons. First, in many
candidate periods and areas, there were too few loans in some LTV
ranges to use the LTV-weighting approach. Second, OFHEO found no
acceptable basis for using any specific, standardized LTV weights.
Finally, OFHEO was concerned that the LTV weighting approach might be
inconsistent with the 1992 Act, because it would not identify the part
of the country where mortgage losses were highest.
Other methodological alternatives were considered by OFHEO in the
procedures for combining the default and severity rates of the two
Enterprises. OFHEO chose to calculate the default and severity rates
for each Enterprise separately for each candidate period and area and
to use the average of the experience of the two Enterprises. OFHEO also
considered averaging the rates based upon the market share of the two
Enterprises, as suggested by the Department of Housing and Urban
Development, but finally determined that attempting to determine the
historical relative market shares of the two Enterprises would be
difficult. Further, OFHEO found the experiences of both Enterprises
equally relevant to a determination of the highest rates of default and
severity and, for this reason also, decided to weight their data
equally.
(ii) General Modeling Approach
This discussion of the general modeling approach focuses on the
macro-decisions made by OFHEO in the development of the stress test.
Given the importance placed upon aligning capital to risk, OFHEO chose
to model the Enterprises' books of business as precisely as possible.
Examples of the decisions made by OFHEO that attempt to balance the
costs against the benefits of precision are discussed below.
As a threshold matter, OFHEO chose to use a cash flow model that,
to the extent possible, determines the cash flows for most instruments
according to their terms, taking into account the availability of data
and the need to avoid excessive complexity and regulatory burden. OFHEO
could have chosen a simpler type of model that calculated gains and
losses on most instruments as ratios of a few baseline instruments. For
example, OFHEO could have assumed that losses on all other loan types
were a fixed multiple of losses on a fixed rate, 30-year, owner-
occupied mortgage loan. The benefit of such a model would have been its
relative simplicity, but the costs of such an approach would have been
a decrease in both the sensitivity of the stress test to risk and the
usefulness of the stress test in aligning capital to risk.
Some commenters suggested that OFHEO adopt an approach similar to
those adopted by the Farm Credit Administration (FCA) and the Federal
Housing Finance Board (FHFB), which involve, to varying degrees, the
use of internal proprietary models. OFHEO considered using internal
models, but differences in regulatory responsibilities make the FCA and
FHFB approaches unworkable for OFHEO. The entire statutory scheme
governing the regulation of the Federal Home Loan Banks by the FHFB,
including the Banks' ownership and capital structure, is very different
from the regulatory framework established by the 1992 Act for the
Enterprises. It is, therefore, reasonable to expect that a very
different type of capital regulation would be required. The statutory
language governing FCA's risk-based capital
[[Page 47798]]
regulations for the Federal Agricultural Mortgage Corporation is very
similar to the language in the 1992 Act, but, because FCA's regulation
applies to only one entity, FCA did not have the same concerns about
consistency between Enterprises that OFHEO does. For the purpose of
regulating Fannie Mae and Freddie Mac, OFHEO determined that the
practical difficulties of implementing and monitoring proprietary,
internal models that are consistent with OFHEO's statute more than
offset any benefit associated with the use of such models. Most
importantly, OFHEO believes that an independently constructed and
administered stress test that measures risk consistently in both
Enterprises is the best method to insure adequate capitalization of the
Enterprises.
(iii) Interest Rates--Yield Curves Considered
The 1992 Act establishes the yield on the ten-year constant
maturity Treasury (CMT) precisely, but for other CMTs requires only
that they move in patterns and for durations relative to the ten-year
CMT that are reasonably related to historical experience and that are
determined to be reasonable by the Director. OFHEO interprets this
latter requirement to require that the yield curves be reasonable
within the context of the stress test and the overall purposes of the
1992 Act.
To select the yield curves, OFHEO examined historical average yield
curves subsequent to significant interest rate movements and observed
that they were consistently flatter the more the ten-year CMT yield
increased and consistently steeper the more the ten-year CMT yield
decreased. Consequently, OFHEO selected yield curves that reflect this
general tendency. The yield curve in the up-rate scenario is flat for
the last nine years of the stress period. In the down-rate scenario,
the yield curve is upward sloping.
In selecting the yield curve for the stress test, OFHEO was guided
by the general level of stringency of the statutorily prescribed
interest rate changes and was mindful of the effect on the relative
level of stress of holding the yield curve constant for a period of
nine years. In the historical data, OFHEO observed more steeply sloping
yield curves than the one selected in the down-rate scenario, and also
observed that in periods of rapidly rising rates the yield curve is
sometimes inverted. If OFHEO had chosen to hold the yield curve
constant at these more unusual slopes, the stress test would have been
more stressful than with the yield curves selected. Instead of these
yield curves, which only exist for short periods of time, OFHEO
selected yield curves that are more representative of a long-term
average after a severe interest rate shock and that are, nevertheless,
unusually stressful.
(iv) Interest Rates--50 Basis Point Premium on Enterprise Cost of Funds
Because the stress test at times generates a need for additional
funding (for example, when Enterprise debt matures more quickly than
loans in portfolio), it was necessary for OFHEO to adopt a decision
rule about the rates at which new debt would be issued. NPR2 specified
that after the first year of the stress period, a 50-basis-point
premium would be added to the projected Agency Cost of Funds to reflect
the premium that would be demanded by the market as a result of the
credit and interest rate stress conditions. The proposal was based on a
review of historical data, which showed a widening of greater than 50
basis points between Enterprise borrowing rates and the ten-year CMT in
response to economic stress on another Government-sponsored enterprise.
Upon consideration of the comments on this issue and after examination
of the relevant historical data and the impact of the premium on
capital requirements, OFHEO decided not to apply the premium to the
Agency Cost of Funds in the final rule.
OFHEO was not convinced by arguments from commenters that the
market would not demand a premium because investors would rely on the
implied Federal guarantee and the Federal regulatory structure to
prevent failure or because other spreads have allegedly widened by as
much or more historically than Government-sponsored enterprises. The
data are too sparse to support either of these conclusions. There has
been only one, relatively brief, period of time in the early 1980s when
one of the Enterprises experienced financial stress approaching the
magnitude specified in the stress test. The only other similar event
involved the Farm Credit System in the mid-1980s.
However, as some comments noted, it is possible that whatever
events might cause a widening of the spread between the Enterprises'
debt rates and Treasuries could also widen spreads of other interest
rates and Treasuries. These spreads have an important effect on the
value of hedging instruments and some Enterprise asset returns, and
further consideration of these spreads may be appropriate. Current data
are insufficient to determine appropriate spreads to the various non-
Treasury rates in the stress test, and data for determining an
appropriate debt premium are sparse. Consequently, OFHEO determined not
to include a premium on new debt in the final rule at this time. This
is, however, a likely area for future research and for refinement of
the rule, because assumptions about these various spreads may comprise
an area of significant risk to the Enterprises.
(v) Property Valuation--Inflation Adjustment
The 1992 Act requires that if interest rates rise by more than 50
percent of the average ten-year CMT for the nine months prior to the
start of the stress test, losses must be adjusted to account for
general inflation. The stress test implements this requirement by
increasing house prices by the amount any ten-year CMT, after the
upward shock in interest rates, exceeds a 50 percent increase in the
average ten-year CMT from the nine months prior to the start of the
stress period. This amount is compounded over the remainder of the
stress period for a cumulative inflation adjustment and applied during
the last 60 months of the stress period.
Some commenters argued that house prices should be increased by the
entire amount of the increase in the ten-year CMT, rather than just the
component in excess of a 50 percent increase. OFHEO rejected this
alternative based on OFHEO's analysis of historical experience of
housing prices during periods of general inflation (as explained in the
section III.H.1.b., Inflation Adjustment) and because it would have
essentially negated the credit stress of the benchmark loss experience.
(vi) Mortgage Performance--General
Models of mortgage performance comprise the central core of the
stress test. Models were the most viable means of complying with the
statutory requirements that the loss rates produced by the model be
reasonably related to the benchmark loss experience and that
appropriate distinctions be made among different types of mortgage
products. These models calculate prepayment and default rates and the
dollar losses associated with the defaults based upon various economic
variables. The models were estimated from data on millions of loans
that were purchased by the Enterprises between 1975 and 1999. Creating
a model that produces reasonable projections of loss under a wide
variety of economic conditions and starting portfolio positions was a
complex task, which involved extensive
[[Page 47799]]
economic analysis and the examination and testing of many different
variables. The decisions made by OFHEO in creating the models are
discussed in detail in the preambles to NPR2 and the final rule. The
most significant of these decisions are summarized below.
(vii) Modeling Conditional vs. Cumulative Rates
Among the threshold issues confronting OFHEO was whether to
construct statistical models of conditional rates of loan defaults and
prepayments or to adopt a less detailed approach, such as calculating
only cumulative rates and distributing them in fixed percentages across
the ten years of the stress period. A conditional rate of default or
prepayment refers to the volume of loans that default or prepay during
any period, expressed as a percentage of the total volume of loans
surviving at the start of that period. The term ``surviving loans''
means those from the group that have not previously prepaid or
defaulted. A cumulative rate of default or prepayment is the total
percentage of a group of loans that default or prepay during the entire
period being studied (such as the ten-year stress period). A group of
loans studied over a ten-year period would have a single cumulative
default rate, but would have 120 monthly conditional default rates.
Comments regarding this aspect of the model were mixed. In their
comments regarding the ANPR, the Enterprises favored using a cumulative
rate model of defaults, with Freddie Mac suggesting that a cumulative
rate of default be extracted from the benchmark loss experience and the
resulting default events be distributed evenly across the stress
period. It was argued that the cumulative approach was much simpler and
would avoid possibly overstating defaults in the up-rate scenario.
Other commenters urged a model of conditional default rates that would
take into consideration the differences in prepayment rates in high-
rate and low-rate environments. After a conditional default and
prepayment rate model was proposed in NPR2, the Enterprises did not
object further.
The final rule uses conditional rather than cumulative default
rates in the stress test. For single family mortgages, the final rule
uses statistical models for the conditional rates of both default and
prepayment. For multifamily mortgages, the final rule combines a
statistical model of conditional default rates with simple rules for
setting conditional prepayment rates. In NPR2, five separate
statistical models of conditional multifamily prepayments were
proposed. OFHEO considered comments about the adequacy of the data to
support these models, whether the models accurately reflected costs
incurred for prepayment within yield maintenance or prepayment penalty
periods, and the overall complexity of the models, and decided that
statistical models of conditional prepayment for multifamily mortgages
would not provide greater precision or risk sensitivity than the simple
set of prepayment rules implemented in the final rule.
The advantages of using conditional rates are numerous. This
approach automatically accounts for the impact of prior defaults on the
number of loans remaining active and subject to the risk of prepayment,
and, conversely, the impact of prior prepayments on the number of loans
remaining subject to the risk of default. This feature is essential to
developing a reasonable representation of Enterprise mortgage cash
flows across the different economic scenarios envisioned by the stress
test. It also avoids potential numerical anomalies that might arise
when total or annual defaults during the stress test are fixed, such as
years in which total defaults would exceed total surviving loans due to
high prepayment levels in the declining rate scenario of the stress
test. Also, the periodic nature of mortgage payments, scheduled
amortization, and the coupon adjustments on adjustable rate loans, all
of which affect mortgage performance, require a model that predicts an
exact number of default and prepayment events in each discrete time
period of the stress test.
OFHEO believes that a statistical model of conditional defaults and
prepayments is more accurate and more sensitive to stress test economic
factors, and to the Enterprises' starting books of business, than are
simpler methods that might be developed. Each quarter the test is
applied, a statistical model can account for changes in economic
conditions (such as the level and shape of the Treasury yield curve or
recent trends in house prices) and the composition of an Enterprise's
business since the last time the test was performed. That is, the rates
of default and prepayment applied when the stress test is run are
adjusted to reflect current circumstances. Such adjustments are
particularly important because mortgage prepayment and default rates
are highly time-dependent, characteristically increasing during the
first years following origination, peaking sometime between the fourth
and seventh years, and declining over the remaining years. However,
this time-dependent pattern is itself affected by economic conditions.
Another advantage of modeling conditional default and prepayment
rates is the support this approach provides for the proper treatment of
loss severity. Loss severity is affected significantly by factors that
affect the timing and amount of defaults in the stress test. Loss of
loan principal balance, the single largest cost element in determining
loss severity, is dependent upon house price declines, which are
dependent upon economic conditions leading up to the date of default.
Funding costs are also affected by the changing interest rates in the
stress test. For all of these reasons, using conditional default and
prepayment rates during each month of the stress period greatly
improves the sensitivity of the stress test to risk factors.
(viii) Use of Joint Default/Prepayment vs. Total Termination Models
Another key issue for OFHEO was whether or not to use joint
prepayment and default models, in which the conditional rates of
default and prepayment interact statistically, or to use some simpler
assumptions about how default and prepayment rates relate to each other
in the stress test.
Fannie Mae favored the use of a statistical model that would
determine only total terminations (defaults plus prepayments) in each
of the two stress test scenarios. The Enterprise further commented that
total defaults in each scenario be set at levels that occurred in the
benchmark loss experience. Prepayments would be calculated by
subtracting total defaults from total terminations. Fannie Mae viewed
this approach as consistent with industry practice and asserted that it
would be easier for the company to manage a capital standard based on
such an approach than one based upon a joint statistical model.
Freddie Mac commented that a joint statistical model of default and
prepayment rates would be preferable to total termination models in the
stress test context because (1) joint models ensure that defaults and
prepayments correctly ``add up'' to total mortgage terminations, (2)
total termination models put undue focus on interest rate movements
because default is a small part of total termination under normal
conditions (an assumption Freddie Mac found unwarranted in a stress
test environment), and (3) standard total termination models capture
small effects such as seasoning that would unnecessarily complicate the
stress test. However, Freddie Mac did not recommend that OFHEO use
joint
[[Page 47800]]
statistical models in the stress test, asserting OFHEO would have
difficulty using the data from the benchmark loss experience to
estimate the models. Instead, Freddie Mac recommended estimating a
statistical equation for prepayments based on historical data from a
distressed region to factor prepayments into the stress test, while
using cumulative default rates from the benchmark loss experience as
the stress test default rates.
As discussed in greater detail in section III.I.1.a., Modeling
Approach, the final rule uses joint statistical models in the stress
test for single family loans, reflecting the recommendations of many
other commenters.\183\ In doing so, OFHEO recognized that models of
mortgage performance are actually models of borrower behavior--
individual borrowers' decisions whether to continue making monthly
mortgage payments, to prepay, or to default. This ``options theoretic''
conceptual framework, which underlies the joint determination of
defaults and prepayments, is the basis for nearly all mortgage
performance research. In sum, the joint modeling approach is based on
well known and accepted statistical methods that are widely applied in
mortgage performance research. Researchers have found multi-choice
statistical models to be necessary for this research, because the
borrower's options to default or prepay are interrelated.
---------------------------------------------------------------------------
\183\ OFHEO found it necessary to use a simpler methodology for
multifamily loans. Because the multifamily model utilizes a set of
prepayment rules, the model is ``joint'' only to the extent that
conditional prepayment and default rates combine to determine loans
that survive from year to year. Conditional rates of default and
prepayment are determined separately. See section III.I.3.,
Multifamily Loan Performance.
---------------------------------------------------------------------------
OFHEO considered the use of total terminations models, such as
those recommended by Fannie Mae's comments on the ANPR, but found joint
statistical models superior for theoretical reasons noted above and
also for reasons cited by Freddie Mac in its comments. However, Freddie
Mac's recommendation to estimate statistical prepayment equations using
historical data from a distressed region while using the cumulative
default rates from the benchmark loss experience was also determined by
OFHEO to be inadequate for the purposes of the regulation. Instead,
OFHEO addressed Freddie Mac's concern about the use of joint models--
specifically, the difficulty of retaining a reasonable relationship to
the benchmark loss experience--in OFHEO's decisions to adjust the
underlying default and severity equations to replicate the benchmark
loss experience, as noted below.
(ix) Relating Mortgage Loss Rates to the Benchmark Loss Experience
One of the challenges in developing a suitable model of mortgage
performance was the statutory requirement that the stress test retain a
reasonable relationship to the benchmark loss experience, while also
taking into consideration a variety of variables such as house price
changes, loan seasoning, and loan type. Ultimately, OFHEO chose to
relate the stress test losses to the benchmark loss experience in two
ways. First, the rule applies certain economic factors from the
benchmark area and time period--specifically, house prices, rent growth
rates and rental vacancy rates--in the stress test. Second, OFHEO
applied the single family mortgage model to the loans used to determine
the benchmark, broken down by loan-to-value ratio (LTV) category and
using the actual interest rates from the benchmark period. The default
and severity rates predicted by the model were then compared to the
higher actual benchmark rates for each LTV category. Ratios of actual
to predicted rates for each category are applied in the default and
severity equations used in the stress test to increase credit losses to
a level reasonably related to the benchmark loss experience.\184\
Modeling the effects of differences in starting coupons and interest
rates from the benchmark loss experience was possible because OFHEO's
database allowed the models to be estimated based upon a broad and
representative sample of historical mortgage performance data. The
statistical equations therefore yield reasonable estimates that can be
used to project mortgage prepayment under many different circumstances,
including stress test interest rate scenarios.
---------------------------------------------------------------------------
\184\ Multifamily loan data are too limited to allow an
adjustment factor to be developed for those loans.
---------------------------------------------------------------------------
There were many different alternatives that OFHEO could have
selected to relate stress test loss rates to the benchmark loss
experience. For example, comments on the ANPR suggested that OFHEO
apply the cumulative default rate from the benchmark loss experience
directly to the current books of business in the stress test. OFHEO
considered this option, which seems simpler in concept than predicting
conditional default probabilities. However, OFHEO determined that
attempting to make adjustments to benchmark default levels to take into
account the various factors specified in the statute and other
appropriate factors would be more complex and less likely to yield
reasonable capital requirements than the approach selected. OFHEO also
considered an approach, which was proposed in NPR2, that would apply
the same benchmark adjustment or calibration factor to all single
family loans regardless of the LTV category. Although simpler than the
final rule, this approach was criticized by many commenters for failing
to take into consideration the mix of LTVs in the benchmark loss
experience, because the difference between model predictions and the
actual loss rates in the benchmark loss experience varied significantly
between LTV categories. Accordingly, in the final rule, different
benchmark adjustment factors are applied for each LTV category.
To summarize, the methodology OFHEO selected relates losses in the
stress test to the benchmark loss experience in a manner that is
reasonable within the context of the entire stress test. More
specifically, the mortgage performance models, with the benchmark
adjustments, not only generate loss rates that are consistent with the
benchmark loss experience, but also produce reasonable loss rates under
a wide variety of starting positions under both the up-rate and down-
rate scenarios. No alternative has been suggested that, in OFHEO's
view, would accomplish these objectives as well as the final rule.
(x) Single Family Mortgage Performance
(a) Default and Prepayment Variable Selection
In selecting appropriate variables to project single family default
and prepayment rates during the stress test, OFHEO considered only
variables that had strong intuitive as well as statistical causal
relationships with mortgage defaults or prepayments. As reflected in
Table 8, certain variables that strongly influenced prepayment behavior
did help to explain defaults. All three single family models simulate
defaults and prepayments based on projected interest rates and property
values and on variables capturing the mortgage risk characteristics
described below.
[[Page 47801]]
Table 8.--Single Family Default & Prepayment Variables
------------------------------------------------------------------------
Single Single
Family Family
Variables for All Single Family Models Default Prepayment
Variables Variables
------------------------------------------------------------------------
Mortgage Age................................ X X
------------------------------------------------------------------------
Original LTV................................ X X
------------------------------------------------------------------------
Probability of Negative Equity.............. X X
------------------------------------------------------------------------
Burnout..................................... X X
------------------------------------------------------------------------
Occupancy Status............................ X X
------------------------------------------------------------------------
Relative Spread............................. X
------------------------------------------------------------------------
Yield Curve Slope........................... X
------------------------------------------------------------------------
Relative Loan Size.......................... X
------------------------------------------------------------------------
Product Type (ARMs, Other Products only).... X X
------------------------------------------------------------------------
Payment Shock (ARMs only)................... X X
------------------------------------------------------------------------
Initial Rate Effect (ARMs only)............. X X
------------------------------------------------------------------------
Mortgage Age--Patterns of mortgage default and prepayment
have characteristic age profiles; defaults and prepayments increase
during the first years following loan origination, with a peak between
the fourth and seventh years.
Original LTV--The LTV at the time of mortgage origination
serves as a proxy for factors relating to the financial status of a
borrower, which reflects the borrower's future ability to make loan
payments. Higher original LTVs, which generally reflect fewer economic
resources and greater financial risk, increase the probability of
default and lower the probability of prepayment. The reverse is true
for lower original LTVs.
Probability of Negative Equity--Borrowers whose current
loan balance is higher than the current value of their mortgaged
property (reflecting negative borrower equity) are more likely to
default than those with positive equity in their properties. The
probability of negative borrower equity within a loan group is a
function of (1) house price changes (based on the HPI) and amortization
of loan principal, which together establish the average current LTV,
and (2) the dispersion of actual house prices around the HPI value.
Thus, even when the average current LTV for a loan group is less than
one (positive equity), some percentage of the loans will have LTVs
greater than one (negative equity).
Burnout--This variable reflects whether a borrower has
passed up earlier opportunities to refinance at favorable interest
rates during the previous eight quarters. Such a borrower is less
likely to prepay the current loan and refinance, and more likely to
default in the future.
Occupancy Status--This variable reflects the higher
probability of default by investor-owners compared with that of owner-
occupants. The RBC Report specifies the proportion of investor loans
for each loan group.
Relative Spread--The stress test uses the relative spread
between the interest rate on a loan and the current market rate on
loans as a proxy for the mortgage premium value, which reflects the
value to a borrower of the option to prepay and refinance.
Yield Curve Slope--This variable measures the relationship
between short and long term interest rates. The shape of the yield
curve, which reflects expectations for the future levels of interest
rates, influences a borrower's decision to prepay a mortgage.
Relative Loan Size--This variable reflects whether a loan
is significantly larger or smaller than the State average. Generally,
lower balance loans are less likely to refinance (and therefore prepay)
because refinancing costs are proportionately larger, and the interest
savings are proportionately smaller, than a larger balance loan.
Product Type--The differences in performance between 30-
year fixed-rate loans and other products, such as ARM and balloon
loans, are captured by this variable.
Payment Shock--This variable captures the effect of
increasing or decreasing interest rates on the payments for ARMs.
Although a borrower with an ARM loan may still have positive equity in
the mortgaged property, the borrower may be unwilling or unable to make
a larger monthly payment when interest rates increase, resulting in
increases to ARM default and prepayment rates. Conversely, decreasing
interest rates make it easier and more desirable for borrowers to make
monthly payments, resulting in lower ARM default and prepayment rates.
Initial Rate Effect--Borrowers with ARM loans with a
``teaser rate'' (an initial interest rate lower than the market rate)
may experience payment shock, even if market rates do not rise, as the
low teaser rate adjusts to the market rate over the first few years of
the loan. The stress test includes a variable which captures this
effect in the first three years of the life of the loan.
OFHEO considered using a number of other variables in both the
default and prepayment equations that had been suggested by commenters
or that appeared to explain default or prepayment rates, but found them
inappropriate for the stress test for various reasons. Unemployment
rates were suggested by several commenters as an appropriate variable,
but, as explained in the preamble to NPR2, OFHEO chose not to make
assumptions about macroeconomic factors, such as unemployment, that are
not specified or required by statute. To use unemployment as a
variable, OFHEO would have to create a model of unemployment rates or
apply simpler assumptions about unemployment rates through the stress
period. OFHEO is not convinced that adding this additional complexity
would improve the rule's sensitivity to risk or otherwise enhance the
rule. Further, the macroeconomic factors of the benchmark area and time
period are captured implicitly to some extent by relating default and
prepayment rates to the benchmark loss experience. Where, however, the
1992 Act required OFHEO to consider economic factors, such as house
prices and interest rates, and OFHEO found those factors strongly
correlated with mortgage performance, OFHEO incorporated them as
variables in the models.
The season-of-the-year variable, originally found useful in
estimating the single family default model, did not improve results
when the model was reestimated for the final rule. Another variable,
relative loan size, which was found significant and included in the
model for prepayments, was determined not to have a significant impact
on defaults.
OFHEO considered comments suggesting that the LTV variable should
provide for further disaggregation of high LTV loans. OFHEO also
considered comments recommending the creation of variables to account
for the use of credit scoring and for subprime lending, structured
mortgages (in which a second mortgage is created coincident with the
first), assumable loans, and loans that were seasoned (as opposed to
newly-originated) at acquisition. Although there is good reason to
believe that these factors influence mortgage performance, OFHEO found
the data and research insufficient to incorporate any of these factors
into the stress test at this time. For example, OFHEO expects that
[[Page 47802]]
automated credit scoring may result in lower default rates, but the
lack of data regarding the impact of credit scoring during economic
experiences equivalent to the benchmark loss experience makes it
difficult to assess to what extent lower recent default rates observed
on credit-scored mortgages would continue during such difficult times.
As more data become available, OFHEO will explore the significance of
these and other new variables and will continue to consider refinements
to the variables that are included currently in the rule. Where
appropriate, OFHEO will consider modifying the stress test to take them
into account. OFHEO recognizes that to remain sensitive to risk, the
stress test must constantly be reevaluated, updated, and refined to
accommodate changes in the Enterprises' businesses and the state of the
art in modeling and risk management. The research and analysis
necessary to retain appropriate sensitivity to risk in the regulation
is central to the mission of OFHEO.
(b) Respecification of ARM Model
OFHEO considered two general alternatives in the modeling of single
family adjustable rate mortgages (ARMs). One possible approach was a
simple model based upon fixed multiples of the 30-year fixed rate
mortgage (FRM) performance. The other alternative required estimating a
separate model for ARM performance. The fixed multiple approach,
although simpler to apply and calculate, failed to take into account
the very different default and prepayment patterns that apply to ARMs
as compared to FRMs. In other words, it is inaccurate to assume that
ARM prepayments and defaults will always be a fixed percentage higher
or lower than on FRMs. Accordingly, OFHEO chose to develop a separate
model of ARM performance that takes into account the variables, such as
payment shock when rates adjust, that uniquely affect ARM performance.
In the final regulation, OFHEO reestimated and respecified the NPR2
ARM models using a pooled dataset of ARMs and 30-year FRMs in order to
compensate for lack of computational detail in Enterprise data for ARM
loans and to respond to comments about the insensitivity of the NPR2
ARM model to payment shock. This reestimation corrected an under-
representation of ARM defaults and prepayments in the data on which the
NPR2 model had been estimated. The respecified ARM model includes the
same set of explanatory variables as the 30-year FRM model, along with
three additional variables unique to ARMs. The additional variables
account for differences in ARM performance relative to 30-year FRMs due
to payment shock, initial (teaser) rate effects, and ARM product type
(to capture other performance differences).
(xi) Multifamily Mortgage Performance
Modeling multifamily loans presented unique challenges for OFHEO,
particularly in light of the lack of clear statutory guidance. When the
1992 Act was being considered by Congress, multifamily lending
comprised a relatively small portion of the Enterprises' total
business. In fact, Freddie Mac had discontinued multifamily lending
altogether at that time. Consequently, no special provision was made
for multifamily loans; the statute generally treated multifamily loans
as just another type of single family loan. Through the 1990s, however,
multifamily lending has grown in importance at both Enterprises and has
become a key element in their strategies to meet affordable housing
goals. What also became clear during that period is that multifamily
loans perform very differently than single family loans. Default and
prepayment behavior of commercial multifamily borrowers is affected by
different factors than single family residential borrowers. Hence,
models designed to simulate the performance of single family loans are
not necessarily appropriate for multifamily loans and vice versa.
Accordingly, OFHEO was required to build a stress test that complies
with the requirements of the 1992 Act (which are oriented toward single
family lending), but nevertheless includes a multifamily performance
model that is sensitive to the risks associated with multifamily loans.
OFHEO achieved this goal by basing the model on the same geographical
region and time period used for the single family model, but exercising
appropriate discretion to ensure that the stress level for multifamily
loans is consistent with that for single family loans. OFHEO was
particularly mindful of comments on NPR2 that highlighted
inappropriately low loss rates for certain categories of multifamily
loans, which would have had the effect of creating perverse business
incentives for an Enterprise. The final rule is based upon a
reestimated model that addresses these and other concerns raised by
commenters, as further explained below.
(a) Multifamily Defaults
OFHEO considered many potential variables and combinations of
variables in constructing the multifamily default model. Given the
increasing importance of multifamily lending to the Enterprises, OFHEO
sought to improve, where possible, upon previous models of multifamily
loan loss behavior and has spent several years testing and evaluating
the factors that affect losses on these loans. In this regard, OFHEO's
proposed rule included the ``double trigger'' variable, which was
designed to measure the likelihood that a particular loan was
experiencing two important determinants of default, negative cash flow
and negative equity, simultaneously. This variable was based upon the
premise that a rational business person would be less likely to default
on a loan so long as the property had either positive equity or
positive cash flow. Although the underlying premise still appears
sound, OFHEO found after further research, conducted in response to
comments, that the proposed means of projecting multifamily property
values during the stress period resulted in unrealistic volatility in
property values and unreasonable loss projections for certain
categories of loans. Accordingly, in the final rule, OFHEO has modified
the multifamily default model to eliminate one of the ``triggers'' and
uses current debt service coverage ratio or ``DCR,'' a measure of net
cash flow, by itself as a variable. In addition, OFHEO has included a
variable that adjusts for the increased probability of default when net
cash flow is negative and a variable that reflects the direct
relationship between LTV at loan origination and the subsequent
likelihood of default. As explained in the preamble to the final rule,
these three variables capture essentially the same mortgage performance
factors that the double trigger was designed to capture, but avoided
the difficulties of projecting multifamily property values over time.
OFHEO also recognized that additional variables were necessary to
account for the fact that the Enterprises underwent major and permanent
changes to their multifamily loan programs beginning in 1988 (Fannie
Mae) and in 1993 (Freddie Mac). Freddie Mac, in particular, had losses
so severe on early multifamily loans that it suspended its multifamily
lending entirely until its programs could be completely overhauled.
Fannie Mae's multifamily lending programs have undergone similar
changes, but somewhat more gradually, since approximately 1988.
In NPR2, OFHEO employed two default models to distinguish between
the Enterprises' loan programs--Negotiated Transactions (NT) and Cash.
Further, a program restructuring
[[Page 47803]]
variable captured the improved performance of multifamily cash loans
after the changes in loan programs described above. Commenters on these
models recommended that the two-model approach be dropped, because the
distinction between the two categories of loans was too difficult to
define and replicate. All commenters on the subject concurred that the
underwriting and servicing practices of the Enterprises underwent major
and permanent changes that should be reflected in the stress test.
These comments came not only from the Enterprises, but also from
multifamily seller-servicers, who were concerned that imposing
inappropriately large marginal capital costs on multifamily loans would
adversely affect seller-servicers, who should be given credit for the
many improvements they had made in originating and servicing
multifamily loans.
In response to the comments, OFHEO created a single multifamily
default model that utilizes two variables to distinguish between
multifamily loan programs. The first of these variables distinguishes
loans based upon their date of origination, crediting loans originated
under more recent programs at both Enterprises with lower default
rates.\185\ The second variable identifies a subset of the newer loans
that were purchased under certain programs at the Enterprises that
include more rigorous and conservative underwriting and servicing
policies. These loans receive additional favorable default treatment.
OFHEO believes that the revised variables accomplish the purpose of
distinguishing the less risky loan programs and product types from
other more risky loan programs and product types better than the
variables used in NPR2. OFHEO further believes that these variables
create appropriate capital incentives for the Enterprises to improve
risk-management in all their multifamily lending programs.
---------------------------------------------------------------------------
\185\ Adjustable-rate loans and fixed-rate balloon loans
exhibited improve performance, but less than fixed-rate fully
amortizing loans. Therefore, different variables are used for these
different loan types.
---------------------------------------------------------------------------
(b) Multifamily Prepayments
OFHEO considered two alternative means to model multifamily loan
prepayments. In NPR2, OFHEO proposed five statistical models of
prepayments that were used for different types of multifamily loans.
These models were similar in some respects to the prepayment model used
for single family loans. None of the comments supported this approach
and many were highly critical of it. Commenters pointed out that
multifamily loans are very different from single family loans and that
assumptions that are incorporated into single family loan models may be
inappropriate for multifamily loans. Commenters also argued that the
prepayment models were overly complex in the number and treatment of
variables. The Enterprises both recommended that the final rule
eliminate much of the complexity of the proposal in favor of using
fixed prepayment percentages for each month of the stress test.
OFHEO considered these comments, studied the operation of the
prepayment model and reviewed the current literature regarding
prepayments. Given the limitations in relevant data, OFHEO concluded
that the commenters were correct, that a statistical model would not
provide greater precision or risk sensitivity than a fixed schedule of
prepayments for each of the two interest rate scenarios. Accordingly,
the final rule adopts such a schedule.\186\
---------------------------------------------------------------------------
\186\ In the up-rate scenario, the final rule includes no
prepayments. In the down-rate scenario, the final rule applies a two
percent annual prepayment rate to loans that are subject to
prepayment penalty provisions and a 25 percent annual rate to loans
that are not subject to these provisions or to loans after the
provisions have expired.
---------------------------------------------------------------------------
(c) Multifamily Loss Severity
To determine appropriate multifamily loan loss severity rates,
OFHEO considered a number of alternatives. In NPR2, OFHEO proposed six
separate calculations for different categories of loans. In estimating
these calculations, OFHEO utilized data from Freddie Mac's multifamily
loans originated in the 1980s. While agreeing with the general
methodology, some commenters argued that it was inappropriate to use
these Freddie Mac data to estimate severity rates. They suggested that
OFHEO add more recent severity data to the sample used to determine
severity rates. In developing the final rule, OFHEO considered this
alternative, but decided to continue using the Freddie Mac data from
the 1980s to determine loss severity rates. OFHEO concluded that these
data represented an appropriately stressful experience from which to
extract severity rates. To the extent that later loan programs have
experienced lower severity rates, data are inadequate to determine how
much of the difference is due to improvement in loan programs and how
much is due to differences in economic conditions. OFHEO also
considered, as an alternative to the NPR2 approach, reducing the six
severity calculations to a single equation. In the final rule, OFHEO
implemented this alternative, because it simplified the stress test
with no demonstrable loss of sensitivity to risk.
(xii) Counterparty Haircuts
In addition to mortgage credit quality, the stress test considers
the creditworthiness of companies and financial instruments to which
the Enterprises have credit exposure. These include most mortgage
credit enhancement counterparties, securities held as assets, and
derivative contract counterparties. The stress test gives credit only
to investment grade counterparties.
For these contract or instrument counterparties, the stress test
reduces--or applies ``haircuts'' to--the amounts due from these
instruments or counterparties according to their level of risk.\187\
The level of risk is determined by public credit ratings at the start
of the stress test, classified into five categories: AAA, AA, A, BBB
and unrated/below BBB. When no rating is available or the instrument or
counterparty has a rating below BBB (below investment grade), the
stress test applies a 100 percent haircut in the first month of the
stress test, with the exception of unrated seller/servicers, which are
treated as BBB. For other categories, the stress test phases in the
haircuts monthly in equal increments until the total reduction listed
in Table 9 is reached five years into the stress period. For the
remainder of the stress test, the maximum haircut applies.
---------------------------------------------------------------------------
\187\ In the case of swaps, the stress test cancels a portion of
``in-the-money'' swaps based on the haircut amount.
Table 9.--Stress Test Final Haircuts by Credit Rating Category
------------------------------------------------------------------------
Nonderivative
Derivative Contract
Ratings Classification Contract Counter-
Counter- parties or
parties Instruments
------------------------------------------------------------------------
AAA 2% 5%
------------------------------------------------------------------------
AA 4% 15%
------------------------------------------------------------------------
A 8% 20%
------------------------------------------------------------------------
BBB 16% 40%
------------------------------------------------------------------------
Unrated/Below BBB \1\ 100% 100%
------------------------------------------------------------------------
\1\ Unrated, unsubordinated obligations issued by Government-sponsored
enterprises other than the reporting Enterprise are treated as AAA.
Unrated seller/servicers are treated as BBB. Other unrated
counterparties and securities are subject to a 100% haircut applied in
the first month of the stress test.
[[Page 47804]]
OFHEO considered a number of alternatives to the haircuts in the
final rule. NPR2 proposed a schedule of non-derivative haircuts that
were approximately double those in the final rule, but were phased in
over ten years rather than five.
In response to comments that those counterparty haircuts were too
severe, OFHEO conducted extensive analysis of the historical data,
including some updated rating agency data and studies submitted by
commenters. As a result, haircuts were lowered. However, OFHEO
determined that phasing the haircuts in more quickly would be more
consistent with the probable impact on counterparties of stress test
conditions. Also in response to comments regarding the proposed rule,
OFHEO added a category that increased the haircuts on below-investment-
grade and unrated counterparties. However, OFHEO decided to except
unrated seller-servicers from this new category, continuing the NPR2
treatment of them as triple-B counterparties. OFHEO found this
exception warranted because of (1) The seller-servicers' close and
ongoing relationships with the Enterprises, (2) the types of controls
available to the Enterprises under their seller-servicer contracts, and
(3) factors other than lack of creditworthiness that may account for
seller-servicers not having a rating, such as their small size. In the
future, OFHEO will consider how Enterprise internal ratings can be used
to make finer, but consistent, risk distinctions between such seller-
servicers.
(xiii) New Debt
NPR2 specified that when the stress test resulted in a cash deficit
requiring the issuance of new debt, all such debt would have a six-
month maturity. OFHEO considered comments recommending a balance of
long- and short-term debt to reflect better the rebalancing strategies
that the Enterprises would be likely to follow. OFHEO agrees with the
comments that a mix of long and short maturities may be more
appropriate, but disagrees with those commenters who suggested that the
stress test specify the issuance of primarily long-term debt as
interest rates rise and short-term debt as they fall. OFHEO did not
believe this approach would create a reasonable model of the reactions
of the Enterprises to interest rate shocks, especially because the
Enterprises do not manage their debt issuances in this manner.
Moreover, it would have created interest rate hedges in both scenarios
that were not appropriate. However, the Enterprises do generally manage
the maturities in their debt portfolios to achieve a balance in the
entire portfolio and OFHEO selected a similar approach to issuing new
debt in the stress test. OFHEO constructed the stress test to add
either long- or short-term debt as required to achieve and maintain a
50/50 balance of long- and short-term debt. The 50/50 balance was
selected because it is more risk-neutral than the proposed approach,
and because OFHEO will not try to model an Enterprise's internal
predictions about whether interest rates will go up or down.
OFHEO also considered whether to change the short-term debt from a
six-month maturity to a one-month maturity, as suggested by some
commenters, but determined that a six-month rate is more representative
of the mix of short-term maturities issued by the Enterprises. OFHEO
also considered a commenter's suggestion to use a ten-year maturity for
the long-term debt, but determined that a five-year callable bond was a
more representative proxy for the typical mix of long-term Enterprise
debt than ten-year bullet debt.
(xiv) Operating Expenses
The proposed decision rule for operating expenses was that these
expenses would decline in proportion to the decline in the mortgage
portfolio. Specifically, the operating expense for a given month was
determined by multiplying the ratio of assets remaining at the end of
each month to assets at the beginning of the stress test by one-third
of the Enterprise's total operating expenses in the quarter immediately
preceding the start of the stress test. No distinction was made between
fixed and variable expenses. This treatment caused the expense
reduction pattern for the up-rate scenario to differ from the down-rate
scenario and within each scenario depending on the changes in the
characteristics of an Enterprise's total mortgage portfolio.
The final rule reflects OFHEO's consideration of comments regarding
the proposed rule, which linked operating expenses directly to the size
of the mortgage portfolio, assumed all operating expenses were
variable, did not exclude a portion of expenses associated with new
business, and tied operating expenses to the previous quarter's
operating expenses. The final rule modifies the proposal in only two
respects. To recognize that operating expenses are partly fixed and
partly variable, one third of each Enterprise's operating expenses at
the start of the stress test remain fixed throughout the stress period,
while the remainder declines in proportion to the decline in the
mortgage portfolio. Secondly, a reduction of one third in the total of
the fixed and variable components has been included to recognize that a
cessation of new business would have a significant impact upon
operating expenses. That reduction is phased in on a straight-line
basis over the first 12 months of the stress period, because it would
take an Enterprise at least that long to implement such a reduction. An
impact of these changes is to reduce the differences in operating
expenses between the up- and down-rate scenarios. OFHEO considered the
Enterprises' recommendation that the stress test use a fixed expense
ratio between 1.5 and 5.0 basis points of unpaid principal balance per
year, but believed such a ratio would be unreasonably low, because, as
one commenter noted, the ratio of Enterprise expenses to outstanding
mortgage-backed securities and portfolio balances has averaged over 7.0
basis points for the past ten years. OFHEO also considered a
commenter's recommendation to hold the level of expenses constant
throughout the stress period based on the experience of financial
institutions under stress. Although this argument has intuitive appeal
for some types of financial institutions, adopting such an approach
would have resulted in unreasonably high capital requirements relative
to operating expenses in OFHEO's stress test. The approach in the final
rule, which fixes only a portion of the expenses, seemed more
appropriate for the Enterprises.
(xv) Distinction Between Preferred and Common Stock Dividends
The final rule adopts the proposed treatment of dividends,
distinguishing between preferred stock and common stock by allowing the
payment of preferred stock dividends as long as an Enterprise meets the
minimum capital requirement, while terminating the payment of common
stock dividends after the first year of the stress test. The payout
rate (dividends as a percentage of earnings) is based on the trend in
earnings. If earnings are increasing, the dividend payout rate is equal
to the average of the payout rate of the preceding four quarters. If
earnings are not increasing, the dividend payout is based on the
preceding quarter's dollar amount of dividends per share. The final
rule also modified the proposal to include repurchases of stock in the
first two quarters of the stress period, based upon any such
repurchases within the previous four quarters.
OFHEO considered and rejected a suggestion to lengthen the look-
back
[[Page 47805]]
period used to determine payout ratios from one to three years. OFHEO
recognizes a shorter look-back period may add volatility in the capital
requirement, but determined that relating the payout to the experience
of the last four quarters is more appropriate because it is more
reflective of current policies, because dividends are only paid for one
year in the stress test, and because market considerations generally
cause companies to be cautious in making changes to dividend policies.
Relating dividend payouts to recent dividend payout experience is also
more consistent with the need to provide a timely early warning of
potential capital deficiencies. For similar reasons, OFHEO also
rejected a proposal to use a long-term industry average dividend rate
of approximately 25 percent of earnings. Also, a review of the
Enterprises' payout ratios over a ten-year period revealed that such
payouts would frequently not have been reflective of reality for each
Enterprise.
(xvi) Capital Calculation
To calculate the amount of capital that an Enterprise would need
just to maintain positive capital during the stress test, the final
rule discounts the monthly capital balances back to the start date of
the stress period and adjusts the starting capital by the lowest of the
discounted capital balances. This approach converts future surpluses or
deficits into current dollars. OFHEO also considered an approach that
would use a series of iterative simulations to adjust the Enterprise's
balance sheet until a starting level of capital was found that was just
sufficient to maintain positive capital throughout the stress period.
Either approach would ensure that an Enterprise would have enough
capital to survive the stress test regardless of when losses associated
with management and operations risk might occur, even if that were the
first day of the stress period. OFHEO adopted the discounting approach
because it is much simpler to design and replicate.
OFHEO rejected a recommendation by the Enterprises to assume that
the amount of capital needed was the simple result of subtracting the
maximum undiscounted amount of total capital consumed during the stress
period from the starting position total capital. Such an approach is
easier to implement, but it does not take into account the time value
of money and would not ensure that the Enterprises hold capital
sufficient to survive the stress test if management and operations
losses occurred at any time during the ten-year stress period. Also,
OFHEO believes that a present-value approach is preferable because it
requires an Enterprise to create a greater capital cushion (as compared
to the Enterprises' recommendation) when credit risk and interest rate
risks are relatively low, making it more likely that an Enterprise can
survive subsequent, more stressful periods.
5. Analysis of Relative Costs and Benefits
The 1992 Act presumptively determined that the benefit/cost ratio
favors a detailed and complete stress test and risk-based capital
regulation such as that in the final rule, and OFHEO has found no
reason to question that judgment. The nation faces huge potential
liabilities and economic disruption if the Enterprises are allowed to
operate in an undercapitalized state, and all parties agree that a
clear capital standard that is also sensitive to risk is an important
tool for avoiding undercapitalization.
OFHEO has balanced the cost of capital or other forms of risk
mitigation against the risk of loss in the Enterprises' operations and
designed a risk-based capital rule that requires adequate capital or
risk mitigation for activities that pose credit or interest rate risk,
while not imposing inordinate costs on any area of the Enterprises'
business. That is, the stress test reflects incremental capital charges
associated with the Enterprises business activities that are consistent
with risk. The stress test imposes higher capital costs on new
activities and unusual activities for which the Enterprises lack
adequate data about risks than on activities for which sufficient data
is available to model them precisely. These higher costs help to insure
that there is adequate capital for the risks that may be associated
with the new or unusual activities and provide appropriate incentives
for the Enterprises to maintain top quality data on all activities and
to pay close attention to risk management. To the extent that requiring
adequate capital may prevent certain innovations from being rushed to
market before their risks are fully understood, OFHEO believes that
result is appropriate.
In any event, OFHEO does not believe that the regulation will
impede innovation and the timely introduction of new activities. The
regulation provides a flexible and responsive procedure that has been
designed to develop appropriate capital treatments as the Enterprises
bring products to market. Moreover, when engaging in activities in
which the financial risks are not fully understood, an Enterprise
should hold capital (or utilize some type of risk mitigation)
sufficient to cover the risks that might be associated with them.
Prudent risk management under a voluntary system would require the
same, and OFHEO's rule is designed to provide a regulatory incentive
for prudent risk management. Further, even in the absence of a risk-
based capital rule, OFHEO's safety and soundness examinations would
require similarly conservative treatments of activities that pose risks
that cannot be quantified accurately.
OFHEO has not performed more detailed analyses of the relative
costs of a voluntary versus a mandatory system, because the 1992 Act
does not make voluntary risk-based capital an option. However, if the
Enterprises were to design and run the stress test internally, OFHEO's
costs might be higher than otherwise, because of the need to monitor
and examine two separate systems. Therefore, OFHEO views the net
difference in cost between a voluntary versus a mandatory risk-based
capital system as likely to be de minimus.
B. Executive Order 13132, Federalism
Executive Order 13132 requires that Executive departments and
agencies identify regulatory actions that have significant Federalism
implications. ``Policies that have Federalism implications'' are
defined as regulations or actions that have substantial direct effects
on the States, on the relationship between the national government and
the States, or on the distribution of power and responsibilities
between the various levels of government. The agency certifies that
this rule has no such Federalism implications.
C. Executive Order 12988, Civil Justice Reform
Executive Order 12988 sets forth guidelines to promote the just and
efficient resolution of civil claims and to reduce the risk of
litigation to the government. The rule meets the applicable standards
of sections 3(a) and (b) of Executive Order 12988.
D. Regulatory Flexibility Act
The Regulatory Flexibility Act (5 U.S.C. 601 et seq.) requires that
a regulation that has a significant economic impact on a substantial
number of small entities must include a regulatory flexibility analysis
describing the rule's impact on small entities. Such an analysis need
not be undertaken if the agency head certifies that the rule will not
have a significant economic impact on a substantial number of small
entities. 5 U.S.C. 605(b).
[[Page 47806]]
OFHEO has considered the impacts of the risk-based capital
regulation under the Regulatory Flexibility Act. The regulation does
not have a significant effect on a substantial number of small entities
since it is applicable only to the Enterprises, which are not small
entities for purposes of the Regulatory Flexibility Act. Therefore, the
General Counsel of OFHEO, acting under delegated authority, has
certified that the regulation will not have a significant economic
impact on a substantial number of small entities.
Although not expressly referencing the Regulatory Flexibility Act,
a trade association representing credit unions requested that OFHEO
address the regulation's impact on its members. OFHEO has determined
that such an analysis is not required. The Regulatory Flexibility Act
requires such an analysis only for entities the agency has direct
statutory authority to regulate. In this case, OFHEO only has direct
authority to regulate the Enterprises.
E. Paperwork Reduction Act
The risk-based capital rule contains no information collection
requirements that require OMB approval under the Paperwork Reduction
Act, 44 U.S.C. Chapter 35.
F. Unfunded Mandates Reform Act
Title II of the Unfunded Mandates Reform Act of 1995 (UMRA)
establishes requirements for Federal agencies to assess the effects of
their regulatory actions on State, local, and tribal governments, and
the private sector. This final rule would not impose any Federal
mandates on any State, local, or tribal governments, or on the private
sector, within the meaning of the UMRA.
List of Subjects in 12 CFR Part 1750
Capital classification, Mortgages, Risk-based capital.
Accordingly, for reasons set forth in the preamble, the Office of
Federal Housing Enterprise Oversight amends 12 CFR part 1750 as
follows:
PART 1750--CAPITAL
1. The authority citation for part 1750 is revised to read as
follows:
Authority: 12 U.S.C. 4513, 4514, 4611, 4612, 4614, 4615, 4618.
2. Add new subpart B to part 1750 to read as follows:
Subpart B--Risk-Based Capital
Sec.
1750.10 General.
1750.11 Definitions.
1750.12 Procedures and timing.
1750.13 Risk-based capital level computation.
Appendix A to subpart B of part 1750--Risk-Based Capital Test
Methodology and Specifications
Subpart B--Risk-Based Capital
Sec. 1750.10 General.
The regulation contained in this subpart B establishes the
methodology for computing the risk-based capital level for each
Enterprise. The board of directors of each Enterprise is responsible
for ensuring that the Enterprise maintains total capital at a level
that is sufficient to ensure the continued financial viability of the
Enterprise and is equal to or exceeds the risk-based capital level
computed pursuant to this subpart B.
Sec. 1750.11 Definitions.
Except where a term is explicitly defined differently in this
subpart, all terms defined at Sec. 1750.2 of subpart A of this part
shall have the same meanings for purposes of this subpart. For purposes
of subpart B of this part, the following definitions shall apply:
(a) Benchmark loss experience means the rates of default and
severity for mortgage loans that--
(1) Were originated during a period of two or more consecutive
calendar years in contiguous areas that together contain at least five
percent of the population of the United States, and
(2) Experienced the highest loss rate for any period of such
duration in comparison with the loans originated in any other
contiguous areas that together contain at least five percent of the
population of the United States.
(b) Constant maturity Treasury yield means the constant maturity
Treasury yield, published by the Board of Governors of the Federal
Reserve System.
(c) Contiguous areas means all the areas within a state or a group
of two or more states sharing common borders. ``Sharing common
borders'' does not mean meeting at a single point. Colorado, for
example, is contiguous with New Mexico, but not with Arizona.
(d) Credit risk means the risk of financial loss to an Enterprise
from nonperformance by borrowers or other obligors on instruments in
which an Enterprise has a financial interest, or as to which the
Enterprise has a financial obligation.
(e) Default rate of a given group of loans means the ratio of the
aggregate original principal balance of the defaulted loans in the
group to the aggregate original principal balance of all loans in the
group.
(f) Defaulted loan means a loan that, within ten years following
its origination:
(1) Resulted in pre-foreclosure sale,
(2) Completed foreclosure,
(3) Resulted in the acquisition of real estate collateral, or
(4) Otherwise resulted in a credit loss to an Enterprise.
(g) Financing costs of property acquired through foreclosure means
the product of:
(1) The number of years (including fractions) of the period from
the completion of foreclosure through disposition of the property,
(2) The average of the Enterprises' short-term funding rates, and
(3) The unpaid principal balance at the time of foreclosure.
(h) Interest rate risk means the risk of financial loss due to the
sensitivity of earnings and net worth of an Enterprise to changes in
interest rates.
(i) Loss on a defaulted loan means:
(1) With respect to a loan in category 1, 2, or 3 of the definition
of defaulted loan the difference between:
(i) The sum of the principal and interest owed when the borrower
lost title to the property securing the mortgage; financing costs
through the date of property disposition; and cash expenses incurred
during the foreclosure process, the holding period for real estate
collateral acquired as a result of default, and the property
liquidation process; and
(ii) The sum of the property sales price and any other liquidation
proceeds (except those resulting from private mortgage insurance
proceeds or other third-party credit enhancements).
(2) With respect to defaulted loans not in categories 1, 2, or 3,
the amount of the financial loss to the Enterprise.
(j) Mortgage means any loan secured by such classes of liens as are
commonly given or are legally effective to secure advances on, or the
unpaid purchase price of, real estate under the laws of the State in
which the real estate is located; or a manufactured house that is
personal property under the laws of the State in which the manufactured
house is located, together with the credit instruments, if any, secured
thereby, and includes interests in mortgages.
(k) Seasoning means the change over time in the ratio of the unpaid
principal balance of a mortgage to the value of the property by which
such mortgage loan is secured.
(l) Severity rate for any group of defaulted loans means the
aggregate losses on all loans in that group divided by the aggregate
original principal balances of those loans.
[[Page 47807]]
(m) Stress period means a hypothetical ten-year period immediately
following the day for which capital is being measured, which is a
period marked by the severely adverse economic circumstances defined in
12 CFR 1750.13 and Appendix A to this subpart.
(n) Total capital means, with respect to an Enterprise, the sum of
the following:
(1) The core capital of the Enterprise;
(2) A general allowance for foreclosure losses, which--
(i) Shall include an allowance for portfolio mortgage losses, an
allowance for non-reimbursable foreclosure costs on government claims,
and an allowance for liabilities reflected on the balance sheet for the
Enterprise for estimated foreclosure losses on mortgage-backed
securities; and
(ii) Shall not include any reserves of the Enterprise made or held
against specific assets.
(3) Any other amounts from sources of funds available to absorb
losses incurred by the Enterprise, that the Director by regulation
determines are appropriate to include in determining total capital.
(o) Type of mortgage product means a classification of one or more
mortgage products, as established by the Director, that have similar
characteristics from each set of characteristics under the paragraphs
(o)(1) through (o)(7) of this section:
(1) The property securing the mortgage is--
(i) A residential property consisting of 1 to 4 dwelling units; or
(ii) A residential property consisting of more than 4 dwelling
units.
(2) The interest rate on the mortgage is---
(i) Fixed; or
(ii) Adjustable.
(3) The priority of the lien securing the mortgage is--
(i) First; or
(ii) Second or other.
(4) The term of the mortgage is--
(i) 1 to 15 years;
(ii) 16-30 years; or
(iii) More than 30 years.
(5) The owner of the property is--
(i) An owner-occupant; or
(ii) An investor.
(6) The unpaid principal balance of the mortgage--
(i) Will amortize completely over the term of the mortgage, and
will not increase significantly at any time during the term of the
mortgage;
(ii) Will not amortize completely over the term of the mortgage,
and will not increase significantly at any time during the term of the
mortgage; or
(iii) May increase significantly at some time during the term of
the mortgage.
(7) Any other characteristics of the mortgage, as specified in
Appendix A to this subpart.
Sec. 1750.12 Procedures and timing.
(a) Each Enterprise shall file with the Director a Risk-Based
Capital Report each quarter, and at such other times as the Director
may require, in his or her discretion. The report shall contain the
information required by the Director in the instructions to the Risk-
Based Capital Report in the format or media specified therein and such
other information as may be required by the Director.
(b) The quarterly Risk-Based Capital Report shall contain
information for the last day of the quarter and shall be submitted not
later than 30 days after the end of the quarter. Reports required by
the Director other than quarterly reports shall be submitted within
such time period as the Director shall specify.
(c) When an Enterprise contemplates entering into a new activity,
as that term is defined in section 3.11 of Appendix A to this subpart,
the Enterprise shall notify the Director as soon as possible while the
transaction or activity is under consideration, but in no event later
than 5 calendar days after settlement or closing. The Enterprise shall
provide to the Director such information regarding the activity as the
Director may require to determine a stress test treatment. OFHEO will
inform the Enterprise as soon as possible thereafter of the proposed
stress test treatment of the new activity. In addition, the notice of
proposed capital classification required by Sec. 1750.21 of subpart C
of this part will inform the Enterprise of the capital treatment of
such new activity used in the determination of the risk-based capital
requirement.
(d) If an Enterprise discovers that a Risk-Based Capital Report
previously filed with OFHEO contains any errors or omissions, the
Enterprise shall notify OFHEO immediately of such discovery and file an
amended Risk-Based Capital Report not later than three days thereafter.
(e) Each capital classification shall be determined by OFHEO on the
basis of the Risk-Based Capital Report filed by the Enterprise under
paragraph (a) of this section; provided that, in the event an amended
Risk-Based Capital Report is filed prior to the issuance of the final
notice of capital classification, the Director has the discretion to
determine the Enterprise's capital classification on the basis of the
amended report.
(f) Each Risk-Based Capital Report or any amended Risk-Based
Capital Report shall contain a declaration by the officer who has been
designated by the Board as responsible for overseeing the capital
adequacy of the Enterprise that the report is true and correct to the
best of such officer's knowledge and belief.
Sec. 1750.13 Risk-based capital level computation.
(a) Risk-Based Capital Test--OFHEO shall compute a risk-based
capital level for each Enterprise at least quarterly by applying the
risk-based capital test described in Appendix A to this subpart to
determine the amount of total capital required for each Enterprise to
maintain positive capital during the stress period. In making this
determination, the Director shall take into account any appropriate
distinctions among types of mortgage products, differences in seasoning
of mortgages, and other factors determined appropriate by the Director
in accordance with the methodology specified in Appendix A to this
subpart. The stress period has the following characteristics:
(1) Credit risk--With respect to mortgages owned or guaranteed by
the Enterprise and other obligations of the Enterprise, losses occur
throughout the United States at a rate of default and severity
reasonably related, in accordance with Appendix A to this subpart, to
the benchmark loss experience.
(2) Interest rate risk--(i) In general. Interest rates decrease as
described in paragraph (a)(2)(ii) of this section or increase as
described in paragraph (a)(2)(iii) of this section, whichever would
require more capital in the stress test for the Enterprise. Appendix A
to this subpart contains a description of the methodology applied to
implement the interest rate scenarios described in paragraphs
(a)(2)(ii) and (iii) of this section.
(ii) Decreases. The 10-year constant maturity Treasury yield
decreases during the first year of the stress period and remains at the
new level for the remainder of the stress period. The yield decreases
to the lesser of-(A) 600 basis points below the average yield during
the 9 months immediately preceding the stress period, or
(B) 60 percent of the average yield during the 3 years immediately
preceding the stress period, but in no case to a yield less than 50
percent of the average yield during the 9 months immediately preceding
the stress period.
(iii) Increases. The 10-year constant maturity Treasury yield
increases during the first year of the stress period
[[Page 47808]]
and will remain at the new level for the remainder of the stress
period. The yield increases to the greater of--
(A) 600 basis points above the average yield during the 9 months
immediately preceding the stress period, or
(B) 160 percent of the average yield during the 3 years immediately
preceding the stress period, but in no case to a yield greater than 175
percent of the average yield during the 9 months immediately preceding
the stress period.
(iv) Different terms to maturity. Yields of Treasury instruments
with terms to maturity other than 10 years will change relative to the
10-year constant maturity Treasury yield in patterns and for durations
that are reasonably related to historical experience and are judged
reasonable by the Director. The methodology used by the Director to
adjust the yields of those other instruments is specified in Appendix A
to this subpart.
(v) Large increases in yields. If the 10-year constant maturity
Treasury yield is assumed to increase by more than 50 percent over the
average yield during the 9 months immediately preceding the stress
period, the Director shall adjust the losses resulting from the
conditions specified in paragraph (a)(2)(iii) of this section to
reflect a correspondingly higher rate of general price inflation. The
method of such adjustment by the Director is specified in Appendix A to
this subpart.
(3) New business. Any contractual commitments of the Enterprise to
purchase mortgages or issue securities will be fulfilled. The
characteristics of resulting mortgages purchased, securities issued,
and other financing will be consistent with the contractual terms of
such commitments, recent experience, and the economic characteristics
of the stress period, as more fully specified in Appendix A to this
subpart. No other purchases of mortgages shall be assumed.
(4) Other activities. Losses or gains on other activities,
including interest rate and foreign exchange hedging activities, shall
be determined by the Director, in accordance with Appendix A to this
subpart and on the basis of available information, to be consistent
with the stress period.
(5) Consistency. Characteristics of the stress period other than
those specifically set forth in paragraph (a) of this section, such as
prepayment experience and dividend policies, will be determined by the
Director, in accordance with Appendix A to this subpart, on the basis
of available information, to be most consistent with the stress period.
(b) Risk-Based Capital Level. The risk-based capital level of an
Enterprise, to be used in determining the appropriate capital
classification of each Enterprise, as required by section 1364 of the
Federal Housing Enterprises Financial Safety and Soundness Act of 1992
(12 U.S.C. 4614), shall be equal to the sum of the following amounts:
(1) Credit and Interest Rate Risk. The amount of total capital
determined by applying the risk-based capital test under paragraph (a)
of this section to the Enterprise.
(2) Management and Operations Risk. To provide for management and
operations risk, 30 percent of the amount of total capital determined
by applying the risk-based capital test under paragraph (a) of this
section to the Enterprise.
Appendix A to Subpart B of Part 1750--Risk-Based Capital Test
Methodology and Specifications
1.0 Identification of the Benchmark Loss Experience
1.1 Definitions
1.2 Data
1.3 Procedures
2.0 Identification of a New Benchmark Loss Experience
3.0 Computation of the Risk-Based Capital Requirement
3.1 Data
3.1.1 Introduction
3.1.2 Risk-Based Capital Report
3.1.2.1 Whole Loan Inputs
3.1.2.2 Mortgage Related Securities Inputs
3.1.2.3 Nonmortgage Instrument Cash Flows Inputs
3.1.2.4 Inputs for Alternative Modeling Treatment Items
3.1.2.5 Operations, Taxes, and Accounting Inputs
3.1.3 Public Data
3.1.3.1 Interest Rates
3.1.3.2 Property Valuation Inputs
3.1.4 Constant Values
3.1.4.1 Single Family Loan Performance
3.1.4.2 Multifamily Loan Performance
3.2 Commitments
3.2.1 Commitments Overview
3.2.2 Commitments Inputs
3.2.2.1 Loan Data
3.2.2.2 Interest Rate Data
3.2.3 Commitments Procedures
3.2.4 Commitments Outputs
3.3 Interest Rates
3.3.1 Interest Rates Overview
3.3.2 Interest Rates Inputs
3.3.3 Interest Rates Procedures
3.3.4 Interest Rates Outputs
3.4 Property Valuation
3.4.1 Property Valuation Overview
3.4.2 Property Valuation Inputs
3.4.3 Property Valuation Procedures for Inflation Adjustment
3.4.4 Property Valuation Outputs
3.5 Counterparty Defaults
3.5.1 Counterparty Defaults Overview
3.5.2 Counterparty Defaults Input
3.5.3 Counterparty Defaults Procedures
3.5.4 Counterparty Defaults Outputs
3.6 Whole Loan Cash Flows
3.6.1 Whole Loan Cash Flows Overview
3.6.2 Whole Loan Cash Flows Inputs
3.6.3 Whole Loan Cash Flows Procedures
3.6.3.1 Timing Conventions
3.6.3.2 Payment Allocation Conventions
3.6.3.3 Mortgage Amortization Schedule
3.6.3.4 Single Family Default and Prepayment Rates
3.6.3.5 Multifamily Default and Prepayment Rates
3.6.3.6 Calculation of Single Family and Multifamily Mortgage
Losses
3.6.3.7 Stress Test Whole Loan Cash Flows
3.6.3.8 Whole Loan Accounting Flows
3.6.4 Final Whole Loan Cash Flow Outputs
3.7 Mortgage-Related Securities Cash Flows
3.7.1 Mortgage-Related Securities Overview
3.7.2 Mortgage-Related Securities Inputs
3.7.2.1 Inputs Specifying Individual Securities
3.7.2.2 Interest Rate Inputs
3.7.2.3 Mortgage Performance Inputs
3.7.2.4 Third-Party Credit Inputs
3.7.3 Mortgage-Related Securities Procedures
3.7.3.1 Single Class MBSs
3.7.3.2 REMICs and Strips
3.7.3.3 Mortgage Revenue Bonds and Miscellaneous MRS
3.7.3.4 Accounting
3.7.4 Mortgage-Related Securities Outputs
3.8 Nonmortgage Instrument Cash Flows
3.8.1 Nonmortgage Instrument Overview
3.8.2 Nonmortgage Instrument Inputs
3.8.3 Nonmortgage Instrument Procedures
3.8.3.1 Apply Specific Calculation Simplifications
3.8.3.2 Determine the Timing of Cash Flows
3.8.3.3 Obtain the Principal Factor Amount at Each Payment Date
3.8.3.4 Calculate the Coupon Factor
3.8.3.5 Project Principal Cash Flows or Changes in the Notional
Amount
3.8.3.6 Project Interest and Dividend Cash Flows
3.8.3.7 Apply Call, Put, or Cancellation Features, if
Applicable
3.8.3.8 Calculate Monthly Interest Accruals for the Life of the
Instrument
3.8.3.9 Calulate Monthly Amotization (Accretion) of Premiums
(Discounts) and Fees
3.8.3.10 Apply Counterparty Haircuts
3.8.4 Nonmortgage Instrument Outputs
3.9 Alternative Modeling Treatments
3.9.1 Alternative Modeling Treatments Overview
3.9.2 Alternative Modeling Treatments Inputs
3.9.3 Alternative Modeling Treatments Procedures
3.9.3.1 Off-Balance Sheet Items
3.9.3.2 Reconciling Items
3.9.3.3 Balance Sheet Items
3.9.4 Alternative Modeling Treatments Outputs
3.10 Operations, Taxes, and Accounting
[[Page 47809]]
3.10.1 Operations, Taxes, and Accounting Overview
3.10.2 Operations, Taxes, and Accounting Inputs
3.10.3 Operations, Taxes, and Accounting Procedures
3.10.3.1 New Debt and Investments
3.10.3.2 Dividends and Share Repurchases
3.10.3.3 Allowances for Loan Losses and Other Charge-Offs
3.10.3.4 Operating Expenses
3.10.3.5 Income Taxes
3.10.3.6 Accounting
3.10.4 Operations, Taxes, and Accounting Outputs
3.11 Treatment of New Enterprise Activities
3.11.1 New Enterprise Activities Overview
3.11.2 New Enterprise Activities Inputs
3.11.3 New Enterprise Activities Procedures
3.11.4 New Enterprise Activities Outputs
3.12 Calculation of the Risk-Based Capital Requirement
3.12.1 Risk-Based Capital Requirement Overview
3.12.2 Risk-Based Capital Requirement Inputs
3.12.3 Risk-Based Capital Requirement Procedures
3.12.4 Risk-Based Capital Requirement Output
4.0 Glossary
1.0 Identification of the Benchmark Loss Experience
OFHEO will use the definitions, data, and methodology described
below to identify the Benchmark Loss Experience.
1.1 Definitions
The terms defined in the Glossary to this Appendix shall apply
for this Appendix.
1.2 Data
[a] OFHEO identifies the Benchmark Loss Experience (BLE) using
historical loan-level data required to be submitted by each of the
two Enterprises. OFHEO's analysis is based entirely on the data
available through 1995 on conventional, 30-year, fixed-rate loans
secured by first liens on single-unit, owner-occupied, detached
properties. For this purpose, detached properties are defined as
single family properties excluding condominiums, planned urban
developments, and cooperatives. The data includes only loans that
were purchased by an Enterprise within 12 months after loan
origination and loans for which the Enterprise has no recourse to
the lender.
[b] OFHEO organizes the data from each Enterprise to create two
substantially consistent data sets. OFHEO separately analyzes
default and severity data from each Enterprise. Default rates are
calculated from loan records meeting the criteria specified above.
Severity rates are calculated from the subset of defaulted loans for
which loss data are available.
1.3 Procedures
[a] Cumulative ten-year default rates for each combination of
states and origination years (state/year combination) that OFHEO
examines are calculated for each Enterprise by grouping all of the
Enterprise's loans originated in that combination of states and
years. For origination years with less than ten-years of loss
experience, cumulative-to-date default rates are used. The two
Enterprise default rates are averaged, yielding an ``average default
rate'' for that state/year combination.
[b] An ``average severity rate'' for each state/year combination
is determined in the same manner as the average default rate. For
each Enterprise, the aggregate severity rate is calculated for all
loans in the relevant state/year combination and the two Enterprise
severity rates are averaged.
[c] The ``loss rate'' for any state/year combination examined is
calculated by multiplying the average default rate for that state/
year combination by the average severity rate for that combination.
[d] The rates of default and Loss Severity of loans in the
state/year combination containing at least two consecutive
origination years and contiguous areas with a total population equal
to or greater than five percent of the population of the United
States with the highest loss rate constitutes the Benchmark Loss
Experience.
2.0 Identification of a New Benchmark Loss Experience
OFHEO will periodically monitor available data and reevaluate
the Benchmark Loss Experience using the methodology set forth in
this Appendix. Using this methodology, OFHEO may identify a new
Benchmark Loss Experience that has a higher rate of loss than the
Benchmark Loss Experience identified at the time of the issuance of
this regulation. In the event such a Benchmark Loss Experience is
identified, OFHEO may incorporate the resulting higher loss rates in
the Stress Test.
3.0 Computation of the Risk-Based Capital Requirement
3.1 Data
3.1.1 Introduction
[a] The Stress Test requires data on all of an Enterprise's
assets, liabilities, stockholders equity, accounting entries,
operations and off-balance sheet obligations, as well as economic
factors that affect them: interest rates, house prices, rent growth
rates, and vacancy rates. The Enterprises are responsible for
compiling and aggregating data on at least a quarterly basis into a
standard format called the Risk-Based Capital Report (RBC Report).
Each Enterprise is required to certify that the RBC Report
submission is complete and accurate. Data on economic factors, such
as interest rates, are compiled from public sources. The Stress Test
uses proprietary and public data directly, and also uses values
derived from such data in the form of constants or default values.
(See Table 3-1, Sources of Stress Test Input Data.) Data fields from
each of these sources for Stress Test computations are described in
the following tables and in each section of this Appendix.
[b] The RBC Report includes information for all the loans owned
or guaranteed by an Enterprise, as well as securities and derivative
contracts, the dollar balances of these instruments and obligations,
as well as all characteristics that bear on their behavior under
stress conditions. As detailed in the RBC Report, data are required
for all the following categories of instruments and obligations:
Mortgages owned by or underlying mortgage-backed securities
(MBS) issued by the Enterprises (whole loans)
Mortgage-related securities
Nonmortgage related securities, whether issued by an
Enterprise, (e.g., debt) or held as investments
Derivative contracts
Other off-balance sheet guarantees (e.g., guarantees of
private-issue securities).
Table 3-1--Sources of Stress Test Input Data
------------------------------------------------------------------------
Data Source(s) R = RBC Report P
= Public Data F = Fixed Values
Section of this Table -----------------------------------
Appendix Intermediate
R P F Outputs
------------------------------------------------------------------------
3.1.3, Public 3-19, Stress Test .... .... F
Data Single Family
Quarterly House
Price Growth
Rates
------------------------------------------------------
3-20, Multifamily .... .... F
Monthly Rent
Growth and
Vacancy Rates
------------------------------------------------------------------------
3.2.2, Characteristics R .... .... 3.3.4, Interest
Commitments of securitized Rates Outputs
Inputs single family
loans originated
and delivered
within 6 months
prior to the
Start of the
Stress Test
------------------------------------------------------------------------
3.2.3, 3-25, Monthly .... .... F
Commitments Deliveries as a
Procedures Percentage of
Commitments
Outstanding
(MDP)
------------------------------------------------------------------------
[[Page 47810]]
3.3.2, Interest 3-18, Interest .... P
Rates Inputs Rate and Index
Inputs
------------------------------------------------------------------------
3.3.3, Interest 3-26, CMT Ratios .... .... F
Rates Procedures to the Ten-Year
CMT
------------------------------------------------------------------------
3.4.2, Property 3-28, Property .... .... .... 3.1.3, Public
Valuation Inputs Valuation Inputs Data
3.3.4, Interest
Rates Outputs
------------------------------------------------------------------------
3.5.3, 3-30, Rating .... P
Counterparty Agencies
Defaults Mappings to
Procedures OFHEO Ratings
Categories
������������������
3-31, Stress Test .... .... F
Maximum Haircut
by Ratings
Classification
------------------------------------------------------------------------
3.6.3.3.2, 3-32, Loan Group .... .... .... 3.3.4, Interest
Mortgage Inputs for Rates Outputs
Amortization Mortgage
Schedule Inputs Amortization
Calculation
------------------------------------------------------------------------
3.6.3.4.2, Single 3-34, Single R .... F 3.6.3.3.4,
Family Default Family Default Mortgage
and Prepayment and Prepayment Amortization
Inputs Inputs Schedule
Outputs
------------------------------------------------------------------------
3.6.3.4.3.2, 3-35, .... .... F
Prepayment and Coefficients for
Default Rates Single Family
and Performance Default and
Fractions Prepayment
Explanatory
Variables
------------------------------------------------------------------------
3.6.3.5.2, 3-38, Loan Group R .... F
Multifamily Inputs for
Default and Multifamily
Prepayment Default and
Inputs Prepayment
Calculations
------------------------------------------------------------------------
3.6.3.5.3.2, 3-39, Explanatory .... .... F 3.6.3.3.4,
Default and Variable Mortgage
Prepayment Rates Coefficients for Amortization
and Performance Multifamily Schedule
Fractions Default Outputs
------------------------------------------------------------------------
3.6.3.6.2.2, 3-42, Loan Group .... .... F 3.3.4, Interest
Single Family Inputs for Gross Rates Outputs
Gross Loss Loss Severity 3.6.3.3.4,
Severity Inputs Mortgage
Amortization
Schedule
Outputs
3.6.3.4.4,
Single Family
Default and
Prepayment
Outputs
------------------------------------------------------------------------
3.6.3.6.3.2, 3-44, Loan Group .... .... F 3.3.4, Interest
Multifamily Inputs for Rates Outputs
Gross Loss Multifamily 3.6.3.3.4,
Severity Inputs Gross Loss Mortgage
Severity Amortization
Schedule
Outputs
------------------------------------------------------------------------
3.6.3.6.4.2, 3-10, CE Inputs R .... .... 3.6.3.3.4,
Mortgage Credit for each Loan Mortgage
Enhancement Group Amortization
Inputs Schedule
Outputs
3.6.3.4.4,
Single Family
Default and
Prepayment
Outputs
3.6.3.5.4,
Multifamily
Default and
Prepayment
Outputs
3.6.3.6.2.4,
Single Family
Gross Loss
Severity
Outputs
3.6.3.6.3.4,
Multifamily
Gross Loss
Severity
Outputs
------------------------------------------------------
3-47, Inputs for R
each Distinct CE
Combination
(DCC)
------------------------------------------------------------------------
3.6.3.7.2, Stress 3-51, Inputs for R .... .... 3.3.4, Interest
Test Whole Loan Final Rates Outputs
Cash Flow Inputs Calculation of 3.6.3.3.4,
Stress Test Mortgage
Whole Loan Cash Amortization
Flows Schedule
Outputs
3.6.3.4.4,
Single Family
Default and
Prepayment
Outputs
3.6.3.5.4,
Multifamily
Default and
Prepayment
Outputs
3.6.3.6.5.2,
Single Family
and Multifamily
Net Loss
Severity
Outputs
------------------------------------------------------------------------
3.6.3.8.2, Whole 3-54, Inputs for R .... .... 3.6.3.7.4,
Loan Accounting Whole Loan Stress Test
Flows Inputs Accounting Flows Whole Loan Cash
Flow Outputs
------------------------------------------------------------------------
3.7.2, Mortgage- 3-56, RBC Report R
Related Inputs for
Securities Single Class MBS
Inputs Cash Flows
------------------------------------------------------
3-57, RBC Report R
Inputs for Multi-
Class and
Derivative MBS
Cash Flows
------------------------------------------------------
3-58, RBC Report R
Inputs for MRBs
and Derivative
MBS Cash Flows
------------------------------------------------------------------------
3.8.2, 3-65, Input R
Nonmortgage Variables for
Instrument Nonmortgage
Inputs Instrument Cash
flows
------------------------------------------------------------------------
[[Page 47811]]
3.9.2, 3-69, Alternative R
Alternative Modeling
Modeling Treatment Inputs
Treatments
Inputs
------------------------------------------------------------------------
3.10.2, 3-70, Operations, R .... .... 3.3.4, Interest
Operations, Taxes, and Rates Outputs
Taxes, and Accounting 3.6.3.7.4,
Accounting Inputs Stress Test
Inputs Whole Loan Cash
Flow Outputs
3.7.4, Mortgage-
Related
Securities
Outputs
3.8.4,
Nonmortgage
Instrument
Outputs
------------------------------------------------------------------------
3.12.2, Risk- ................. R .... .... 3.3.4, Interest
Based Capital Rates Outputs
Requirement 3.9.4,
Inputs Alternative
Modeling
Treatments
Outputs
3.10.4,
Operations,
Taxes, and
Accounting
Outputs
------------------------------------------------------------------------
3.1.2 Risk-Based Capital Report
The Risk-Based Capital Report is comprised of information on
whole loans, mortgage-related securities, nonmortgage instruments
(including liabilities and derivatives), and accounting items
(including off-balance sheet guarantees). In addition to their
reported data, the Enterprises may report scale factors in order to
reconcile this reported data with their published financials (see
section 3.10.2[b] of this Appendix). If so, specific data items, as
indicated, are adjusted by appropriate scale factors before any
calculations occur.
3.1.2.1 Whole Loan Inputs
[a] Whole loans are individual single family or multifamily
mortgage loans. The Stress Test distinguishes between whole loans
that the Enterprises hold in their investment portfolios (retained
loans) and those that underlie mortgage-backed securities (sold
loans). Consistent with Table 3-2, Whole Loan Classification
Variables, each Enterprise aggregates the data for loans with
similar portfolio (retained or sold), risk, and product
characteristics. The characteristics of these loan groups determine
rates of mortgage Default, Prepayment and Loss Severity and cash
flows.
[b] The characteristics that are the basis for loan groups are
called ``classification variables'' and reflect categories, e.g.,
fixed interest rate versus floating interest rate, or identify a
value range, e.g., original loan-to-value (LTV) ratio greater than
80 percent and less than or equal to 90 percent.
[c] All loans with the same values for each of the relevant
classification variables included in 3-2 (and where applicable 3-3
and 3-4) comprise a single loan group. For example, one loan group
includes all loans with the following characteristics:
Single family
Sold portfolio
30-year fixed rate conventional loan
Mortgage age greater than or equal to 36 months and less
than 48 months
Original LTV greater than 75 percent and less than or equal
to 80 percent
Current mortgage interest rate class greater than or equal
to six percent and less than seven percent
Secured by property located in the East North Central
Census Division
Relative loan size greater than or equal to 75 percent and
less than 100 percent of the average for its state and origination
year.
Table 3-2--Whole Loan Classification Variables
----------------------------------------------------------------------------------------------------------------
Variable Description Range
----------------------------------------------------------------------------------------------------------------
Reporting Date The last day of the quarter for the YYYY0331
loan group activity that is being YYYY0630
reported to OFHEO YYYY0930
YYYY1231
----------------------------------------------------------------------------------------------------------------
Enterprise Enterprise submitting the loan group Fannie Mae
data Freddie Mac
----------------------------------------------------------------------------------------------------------------
Business Type Single family or multifamily Single family
Multifamily
----------------------------------------------------------------------------------------------------------------
Portfolio Type Retained portfolio or Sold portfolio Retained Portfolio
Sold Portfolio
----------------------------------------------------------------------------------------------------------------
Government Flag Conventional or Government insured Conventional
loan Government
----------------------------------------------------------------------------------------------------------------
Original LTV Assigned LTV classes based on the LTV=60
ratio, in percent, between the 60 LTV=70
original loan amount and the lesser 70 LTV=75
of the purchase price or appraised 75 LTV=80
value 80 LTV=90
90 LTV=95
95 LTV=100
100 LTV
----------------------------------------------------------------------------------------------------------------
Current Mortgage Interest Rate Assigned classes for the current 0.0=Rate4.0
mortgage interest rate 4.0=Rate5.0
[[Page 47812]]
5.0=Rate6.0
6.0=Rate7.0
7.0=Rate8.0
8.0=Rate9.0
9.0=Rate10.0
10.0=Rate11.0
11.0=Rate12.0
12.0=Rate13.0
13.0=Rate14.0
14.0=Rate15.0
15.0=Rate16.0
Rate=>16.0
----------------------------------------------------------------------------------------------------------------
Original Mortgage Interest Rate Assigned classes for the original 0.0=Rate4.0
mortgage interest rate 4.0=Rate5.0
5.0=Rate6.0
6.0=Rate7.0
7.0=Rate8.0
8.0=Rate9.0
9.0=Rate10.0
10.0=Rate11.0
11.0=Rate12.0
12.0=Rate13.0
13.0=Rate14.0
14.0=Rate15.0
15.0=Rate16.0
Rate=>16.0
----------------------------------------------------------------------------------------------------------------
Mortgage Age Assigned classes for the age of the 0=Age12
loan 12=Age24
24=Age36
36=Age48
48=Age60
60=Age72
72=Age84
84=Age96
96=Age108
108=Age120
120=Age132
132=Age144
144=Age156
156=Age168
168=Age180
Age>=180
----------------------------------------------------------------------------------------------------------------
Rate Reset Period Assigned classes for the number of Period =1
months between rate adjustments 1 Period =4
4 Period =9
9 Period =15
15 Period =60
Period >60
----------------------------------------------------------------------------------------------------------------
Payment Reset Period Assigned classes for the number of Period =9
months between payment adjustments 9 Period =15
after the duration of the teaser Period >15
rate
----------------------------------------------------------------------------------------------------------------
ARM Index Specifies the type of index used to FHLB 11th District Cost of Funds.
determine the interest rate at each 1 Month Federal Agency Cost of
adjustment Funds.
3 Month Federal Agency Cost of
Funds.
6 Month Federal Agency Cost of
Funds.
12 Month Federal Agency Cost of
Funds.
24 Month Federal Agency Cost of
Funds.
36 Month Federal Agency Cost of
Funds.
60 Month Federal Agency Cost of
Funds.
120 Month Federal Agency Cost of
Funds.
360 Month Federal Agency Cost of
Funds.
Overnight Federal Funds (Effective).
1 Week Federal Funds
6 Month Federal Funds
1 month LIBOR
3 Month LIBOR
6 Month LIBOR
12 Month LIBOR
Conventional Mortgage Rate.
15 Year Fixed Mortgage Rate.
7 Year Balloon Mortgage Rate.
Prime Rate
1 Month Treasury Bill
3 Month CMT
6 Month CMT
12 Month CMT
[[Page 47813]]
24 Month CMT
36 Month CMT
60 Month CMT
120 Month CMT
240 Month CMT
360 Month CMT
----------------------------------------------------------------------------------------------------------------
Cap Type Flag Indicates if a loan group is rate- Payment Capped
capped, payment-capped or uncapped Rate Capped
No periodic rate cap
----------------------------------------------------------------------------------------------------------------
Table 3-3--Additional Single Family Loan Classification Variables
----------------------------------------------------------------------------------------------------------------
Variable Description Range
----------------------------------------------------------------------------------------------------------------
Single Family Product Code Identifies the mortgage product Fixed Rate 30YR
types for single family loans Fixed Rate 20YR
Fixed Rate 15YR
5 Year Fixed Rate Balloon
7 Year Fixed Rate Balloon
10 Year Fixed Rate Balloon
15 Year Fixed Rate Balloon
Adjustable Rate
Second Lien
Other
----------------------------------------------------------------------------------------------------------------
Census Division The Census Division in which the East North Central
property resides. This variable is East South Central
populated based on the property's Middle Atlantic
state code Mountain
New England
Pacific
South Atlantic
West North Central
West South Central
----------------------------------------------------------------------------------------------------------------
Relative Loan Size Assigned classes for the loan amount 0=Size=40%
at origination divided by the 40%Size=60%
simple average of the loan amount 60%Size=75%
for the origination year and for 75%Size=100%
the state in which the property is 100%Size=125%
located. It is expressed as a 125%Size=150%
percent Size>150%
----------------------------------------------------------------------------------------------------------------
Table 3-4--Additional Multifamily Loan Classification Variables
----------------------------------------------------------------------------------------------------------------
Variable Description Range
----------------------------------------------------------------------------------------------------------------
Multifamily Product Code Identifies the mortgage product Fixed Rate Fully Amortizing
types for multifamily loans Adjustable Rate Fully Amortizing
5 Year Fixed Rate Balloon
7 Year Fixed Rate Balloon
10 Year Fixed Rate Balloon
15 Year Fixed Rate Balloon
Balloon ARM
Other
----------------------------------------------------------------------------------------------------------------
New Book Flag ``New Book'' is applied to Fannie New Book
Mae loans acquired beginning in Old Book
1988 and Freddie Mac loans acquired
beginning in 1993, except for loans
that were refinanced to avoid a
default on a loan originated or
acquired earlier
----------------------------------------------------------------------------------------------------------------
Ratio Update Flag Indicates if the LTV and DCR were Yes
updated at origination or at No
Enterprise acquisition
----------------------------------------------------------------------------------------------------------------
Interest Only Flag Indicates if the loan is currently Yes
paying interest only. Loans that No
started as I/Os and are currently
amortizing should be flagged as `N'
----------------------------------------------------------------------------------------------------------------
Current DCR Assigned classes for the Debt DCR 1.00
Service Coverage Ratio based on the 1.00 =DCR1.10
most recent annual operating 1.10 =DCR1.20
statement 1.20 =DCR1.30
1.30 =DCR1.40
1.40 =DCR1.50
1.50 =DCR1.60
1.60 =DCR1.70
1.70 =DCR1.80
[[Page 47814]]
1.80 =DCR1.90
1.90 =DCR2.00
2.00 =DCR2.50
2.50 =DCR4.00
DCR >= 4.00
----------------------------------------------------------------------------------------------------------------
3.1.2.1.1 Loan Group Inputs
Table 3-5--Mortgage Amortization Calculation Inputs
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
Rate Type (Fixed or Adjustable)
------------------------------------------------------------------------
Product Type (30/20/15-Year FRM,
ARM, Balloon, Government, etc.)
------------------------------------------------------------------------
UPBORIG Unpaid Principal Balance at
Origination (aggregate for Loan
Group)
------------------------------------------------------------------------
UPB0 Unpaid Principal Balance at start
of Stress Test (aggregate for Loan
Group), adjusted by UPB scale
factor.
------------------------------------------------------------------------
MIR0 Mortgage Interest Rate for the
Mortgage Payment prior to the
start of the Stress Test, or
Initial Mortgage Interest Rate for
new loans (weighted average for
Loan Group) (expressed as a
decimal per annum)
------------------------------------------------------------------------
PMT0 Amount of the Mortgage Payment
(Principal and Interest) prior to
the start of the Stress Test, or
first Payment for new loans
(aggregate for Loan Group),
adjusted by UPB scale factor.
------------------------------------------------------------------------
AT Original loan Amortizing Term in
months (weighted average for Loan
Group)
------------------------------------------------------------------------
RM Remaining term to Maturity in
months (i.e., number of
contractual payments due between
the start of the Stress Test and
the contractual maturity date of
the loan) (weighted average for
Loan Group)
------------------------------------------------------------------------
A0 Age of the loan at the start of
Stress Test, in months (weighted
average for Loan Group)
------------------------------------------------------------------------
Unamortized Balance Scale Factor Factor determined by reconciling
reported Unamortized Balance to
published financials
------------------------------------------------------------------------
UPB Scale Factor Factor determined by reconciling
reported UPB to published
financials
------------------------------------------------------------------------
Additional Interest Rate Inputs
------------------------------------------------------------------------
GFR Guarantee Fee Rate (weighted
average for Loan Group) (decimal
per annum)
------------------------------------------------------------------------
SFR Servicing Fee Rate (weighted
average for Loan Group) (decimal
per annum)
------------------------------------------------------------------------
Additional Inputs for ARMs (weighted averages for Loan Group, except for
Index)
------------------------------------------------------------------------
INDEXm Monthly values of the contractual
Interest Rate Index
------------------------------------------------------------------------
LB Look-Back period, in months
------------------------------------------------------------------------
MARGIN Loan Margin (over index), decimal
per annum
------------------------------------------------------------------------
RRP Rate Reset Period, in months
------------------------------------------------------------------------
Rate Reset Limit (up and down),
decimal per annum
------------------------------------------------------------------------
Maximum Rate (life cap), decimal
per annum
------------------------------------------------------------------------
Minimum Rate (life floor), decimal
per annum
------------------------------------------------------------------------
NAC Negative Amortization Cap, decimal
fraction of UPBORIG
------------------------------------------------------------------------
Unlimited Payment Reset Period, in
months
------------------------------------------------------------------------
PRP Payment Reset Period, in months
------------------------------------------------------------------------
Payment Reset Limit, as decimal
fraction of prior payment
------------------------------------------------------------------------
IRP Initial Rate Period, in months
------------------------------------------------------------------------
Additional Inputs for Multifamily Loans
------------------------------------------------------------------------
Interest-only Flag
------------------------------------------------------------------------
RIOP Remaining Interest-only period, in
months (weighted average for loan
group)
------------------------------------------------------------------------
[[Page 47815]]
Table 3-6--Additional Inputs for Single Family Default and Prepayment
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
PROD Mortgage Product Type
------------------------------------------------------------------------
A0 Age immediately prior to start of
Stress Test, in months (weighted
average for Loan Group)
------------------------------------------------------------------------
LTVORIG Loan-to-Value ratio at Origination
(weighted average for Loan Group)
------------------------------------------------------------------------
UPBORIG UPB at Origination (aggregate for
Loan Group), adjusted by UPB scale
factor.
------------------------------------------------------------------------
MIRORIG Mortgage Interest Rate at
origination (``Initial Rate'' for
ARMs), decimal per annum (weighted
average for loan group)
------------------------------------------------------------------------
UPB0 Unpaid Principal Balance
immediately prior to start of
Stress Test (aggregate for Loan
Group),
------------------------------------------------------------------------
IF Fraction (by UPB, in decimal form)
of Loan Group backed by Investor-
owned properties
------------------------------------------------------------------------
RLSORIG Weighted average Relative Loan Size
at Origination (Original UPB as a
fraction of average UPB for the
state and Origination Year of loan
origination)
------------------------------------------------------------------------
CHPGF0LG Cumulative House Price Growth
Factor since Loan Origination
(weighted average for Loan Group)
------------------------------------------------------------------------
Table 3-7--Additional Inputs for Multifamily Default and Prepayment
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
Mortgage Product Type
------------------------------------------------------------------------
A0 Age immediately prior to start of
Stress Test, in months (weighted
average for Loan Group)
------------------------------------------------------------------------
NBF New Book Flag
------------------------------------------------------------------------
RUF Ratio Update Flag
------------------------------------------------------------------------
LTVORIG Loan-to-Value ratio at loan
origination
------------------------------------------------------------------------
DCR0 Debt Service Coverage Ratio at the
start of the Stress Test
------------------------------------------------------------------------
PMT0 Amount of the mortgage payment
(principal and interest) prior to
the start of the Stress Test, or
first payment for new loans
(aggregate for Loan Group)
------------------------------------------------------------------------
PPEM Prepayment Penalty End Month number
in the Stress Test (weighted
average for Loan Group)
------------------------------------------------------------------------
RM Remaining term to Maturity in
months (i.e., number of
contractual payments due between
the start of the Stress Test and
the contractual maturity date of
the loan) (weighted average for
Loan Group)
------------------------------------------------------------------------
Table 3-8--Miscellaneous Whole Loan Cash and Accounting Flow Inputs
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
GF Guarantee Fee rate (weighted
average for Loan Group) (decimal
per annum)
------------------------------------------------------------------------
FDS Float Days for Scheduled Principal
and Interest
------------------------------------------------------------------------
FDP Float Days for Prepaid Principal
------------------------------------------------------------------------
FREP Fraction Repurchased (weighted
average for Loan Group) (decimal)
------------------------------------------------------------------------
RM Remaining Term to Maturity in
months
------------------------------------------------------------------------
UPD0 Unamortized Premium (positive) or
Discount (negative) (Deferred
Balances) for the Loan Group at
the start of the Stress Test,
adjusted by Unamortized Balance
scale factor
------------------------------------------------------------------------
SUPD0 Security Unamortized Premium
(positive) or Discount (negative)
associated with the repurchase
price of a Repurchased MBS
(aggregate over all purchases of
the same MBS)
------------------------------------------------------------------------
Table 3-9--Additional Inputs for Repurchased MBS
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
Wtd Ave Percent Repurchased For sold loan groups, the percent
of the loan group UPB that gives
the actual dollar amount of loans
that collateralize single class
MBSs that the Enterprise holds in
its own portfolio
------------------------------------------------------------------------
Security Unamortized Balances The aggregate sum of all
unamortized discounts, premiums,
fees, commissions, etc. associated
with the securities modeled using
the Wtd Ave Percent Repurchased
------------------------------------------------------------------------
3.1.2.1.2 Credit Enhancement Inputs
To calculate reductions in mortgage credit losses due to credit
enhancements, the following data are required for any credit-
enhanced loans in a loan group. For this purpose, a Loan Group is
divided into Distinct Credit Enhancement Combinations, as further
described in section 3.6.3.6.4,
[[Page 47816]]
Mortgage Credit Enhancement, of this Appendix.
Table 3-10--CE Inputs for Each Loan Group
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
UPBORIGLG Origination UPB.
------------------------------------------------------------------------
LTV ORIGLG Original LTV.
------------------------------------------------------------------------
Table 3-11--Inputs for Each Distinct CE Combination (DCC)
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
PDCC Percent of Initial Loan Group UPB
represented by individual loan(s)
in a DCC
------------------------------------------------------------------------
RMI,DCC or RLSA,DCC Credit rating of Loan Limit CE (MI
or LSA) Counterparty
------------------------------------------------------------------------
CMI,DCC or CLSA,DCC Weighted Average Coverage
Percentage for MI or LSA Coverage
(weighted by Initial UPB)
------------------------------------------------------------------------
AB0DCC,C1 DCC Available First Priority CE
Balance immediately prior to start
of the Stress Test
------------------------------------------------------------------------
AB0DCC,C2 DCC Available Second Priority CE
Balance immediately prior to start
of the Stress Test
------------------------------------------------------------------------
RDCC,C1 DCC Credit Rating of First Priority
CE Provider or Counterparty; or
Cash/Cash Equivalent (which is not
Haircutted)
------------------------------------------------------------------------
RDCC,C2 DCC Credit Rating of Second
Priority CE Provider or
Counterparty; or Cash/Cash
Equivalent (which is not
Haircutted)
------------------------------------------------------------------------
CDCC,C1 DCC Loan-Level Coverage Limit of
First Priority Contract (If
Subtype is MPI; otherwise = 1)
------------------------------------------------------------------------
CDCC,C2 DCC Loan-Limit Coverage Limit of
Second Priority Contract (if
Subtype is MPI; otherwise = 1)
------------------------------------------------------------------------
ExpMoDCC,C1 Month in the Stress Test (1...120
or after) in which the DCC First
Priority Contract expires
------------------------------------------------------------------------
ExpMoDCC,C2 Month in the Stress Test (1...120
or after) in which the DCC Second
Priority Contract expires
------------------------------------------------------------------------
ELPFDCC,C1 DCC Enterprise Loss Position Flag
for First Priority Contract (Y or
N)
------------------------------------------------------------------------
ELPFDCC,C2 DCC Enterprise Loss Position Flag
for Second Priority Contract (Y or
N)
------------------------------------------------------------------------
3.1.2.1.3 Commitments Inputs
[a] The Enterprises report Commitment Loan Group categories
based on specific product type characteristics of securitized single
family loans originated and delivered during the six months prior to
the start of the Stress Test (see section 3.2, Commitments, of this
Appendix). For each category, the Enterprises report the same
information as for Whole Loan Groups with the following exceptions:
1. Amortization term and remaining term are set to those
appropriate for newly originated loans;
2. Unamortized balances are set to zero;
3. The House Price Growth Factor is set to one;
4. Age is set to zero;
5. Any credit enhancement coverage other than mortgage insurance
is not reported.
3.1.2.2 Mortgage Related Securities Inputs
[a] The Enterprises hold mortgage-related securities, including
single class and Derivative Mortgage-Backed Securities (certain
multi-class and strip securities) issued by Fannie Mae, Freddie Mac,
and Ginnie Mae; mortgage revenue bonds issued by State and local
governments and their instrumentalities; and single class and
Derivative Mortgage-Backed Securities issued by private entities.
The Stress Test models the cash flows of these securities
individually. Table 3-12, Inputs for Single Class MBS Cash Flows
sets forth the data elements that the Enterprises must compile in
the RBC Report regarding each MBS held in their portfolios. This
information is necessary for determining associated cash flows in
the Stress Test.
Table 3-12--Inputs for Single Class MBS Cash Flows
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
Pool Number A unique number identifying each
mortgage pool
------------------------------------------------------------------------
CUSIP Number A unique number assigned to
publicly traded securities by the
Committee on Uniform Securities
Identification Procedures
------------------------------------------------------------------------
Issuer Issuer of the mortgage pool
------------------------------------------------------------------------
Government Flag Indicates Government insured
collateral
------------------------------------------------------------------------
Original UPB Amount Original pool balance adjusted by
UPB scale factor and multiplied by
the Enterprise's percentage
ownership
------------------------------------------------------------------------
Current UPB Amount Initial Pool balance (at the start
of the Stress Test), adjusted by
UPB scale factor and multiplied by
the Enterprise's percentage
ownership
------------------------------------------------------------------------
Product Code Mortgage product type for the pool
------------------------------------------------------------------------
Security Rate Index If the rate on the security adjusts
over time, the index that the
adjustment is based on
------------------------------------------------------------------------
Unamortized Balance The sum of all unamortized
discounts, premiums, fees,
commissions, etc. adjusted by
Unamortized Balance scale factor
------------------------------------------------------------------------
[[Page 47817]]
Wt Avg Original Amortization Term Original amortization term of the
underlying loans, in months
(weighted average for underlying
loans)
------------------------------------------------------------------------
Wt Avg Remaining Term of Maturity Remaining maturity of the
underlying loans at the start of
the Stress Test (weighted average
for underlying loans)
------------------------------------------------------------------------
Wt Avg Age Age of the underlying loans at the
start of the Stress Test (weighted
average for underlying loans)
------------------------------------------------------------------------
Wt Avg Current Mortgage Interest Mortgage Interest Rate of the
rate underlying loans at the start of
the Stress Test (weighted average
for underlying loans)
------------------------------------------------------------------------
Wt Avg Pass-Through Rate Pass-Through Rate of the underlying
loans at the start of the Stress
Test (Sold loans only) (weighted
average for underlying loans)
------------------------------------------------------------------------
Wt Avg Original Mortgage Interest The current UPB weighted average
Rate mortgage interest rate in effect
at origination for the loans in
the pool
------------------------------------------------------------------------
Security Rating The most current rating issued by
any Nationally Recognized
Statistical Rating Organization
(NRSRO) for this security, as of
the reporting date
------------------------------------------------------------------------
Wt Avg Gross Margin Gross margin for the underlying
loans (ARM MBS only) (weighted
average for underlying loans)
------------------------------------------------------------------------
Wt Avg Net Margin Net margin (used to determine the
security rate for ARM MBS)
(weighted average for underlying
loans)
------------------------------------------------------------------------
Wt Avg Rate Reset Period Rate reset period in months (ARM
MBS only) (weighted average for
underlying loans)
------------------------------------------------------------------------
Wt Avg Rate Reset Limit Rate reset limit up/down (ARM MBS
only) (weighted average for
underlying loans)
------------------------------------------------------------------------
Wt Avg Life Interest Rate Ceiling Maximum rate (lifetime cap) (ARM
MBS only) (weighted average for
underlying loans)
------------------------------------------------------------------------
Wt Avg Life Interest Rate Floor Minimum rate (lifetime floor) (ARM
MBS only) (weighted average for
underlying loans)
------------------------------------------------------------------------
Wt Avg Payment Reset Period Payment reset period in months (ARM
MBS only) (weighted average for
underlying loans)
------------------------------------------------------------------------
Wt Avg Payment Reset Limit Payment reset limit up/down (ARM
MBS only) (weighted average for
underlying loans)
------------------------------------------------------------------------
Wt Avg Lockback Period The number of months to look back
from the interest rate change date
to find the index value that will
be used to determine the next
interest rate. (weighted average
for underlying loans)
------------------------------------------------------------------------
Wt Avg Negative Amortization Cap The maximum amount to which the
balance can increase before the
payment is recast to a fully
amortizing amount. It is expressed
as a fraction of the original UPB.
(weighted average for underlying
loans)
------------------------------------------------------------------------
Wt Avg Original Mortgage Interest The current UPB weighted average
Rate original mortgage interest rate
for the loans in the pool
------------------------------------------------------------------------
Wt Avg Initial Interest Rate Number of months between the loan
Period origination date and the first
rate adjustment date (weighted
average for underlying loans)
------------------------------------------------------------------------
Wt Avg Unlimited Payment Reset Number of months between unlimited
Period payment resets i.e., not limited
by payment caps, starting with
origination date (weighted average
for underlying loans)
------------------------------------------------------------------------
Notional Flag Indicates if the amounts reported
in Original Security Balance and
Current Security Balance are
notional
------------------------------------------------------------------------
UPB Scale Factor Factor determined by reconciling
reported UPB to published
financials
------------------------------------------------------------------------
Unamortized Balance Scale Factor Factor determined by reconciling
reported Unamortized Balance to
published financials
------------------------------------------------------------------------
Whole Loan Modeling Flag Indicates that the Current UPB
Amount and Unamortized Balance
associated with this repurchased
MBS are included in the Wt Avg
Percent Repurchased and Security
Unamortized Balance fields
------------------------------------------------------------------------
FAS 115 Classification The financial instrument's
classification according to FAS
115
------------------------------------------------------------------------
HPGRK Vector of House Price Growth Rates
for quarters q =1...40 of the
Stress Period
------------------------------------------------------------------------
[b] Table 3-13, Information for Multi-Class and Derivative MBS
Cash Flows Inputs sets forth the data elements that the Enterprises
must compile regarding multi-class and Derivative MBS (e.g., REMICs
and Strips). This information is necessary for determining
associated cash flows in the Stress Test.
Table 3-13--Information for Multi-Class and Derivative MBS Cash Flows
Inputs
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
CUSIP Number A unique number assigned to
publicly traded securities by the
Committee on Uniform Securities
Identification Procedures
------------------------------------------------------------------------
Issuer Issuer of the security: FNMA,
FHLMC, GNMA or other
------------------------------------------------------------------------
Original Security Balance Original principal balance of the
security (notional amount for
interest-only securities) at the
time of issuance, adjusted by UPB
scale factor, multiplied by the
Enterprise's percentage ownership
------------------------------------------------------------------------
[[Page 47818]]
Current Security Balance Initial principal balance, or
notional amount, at the start of
the Stress Period, adjusted by UPB
scale factor, multiplied by the
Enterprise's percentage ownership
------------------------------------------------------------------------
Current Security Percentage Owned The percentage of a security's
total current balance owned by the
Enterprise
------------------------------------------------------------------------
Notional Flag Indicates if the amounts reported
in Original Security Balance and
Current Security Balance are
notional
------------------------------------------------------------------------
Unamortized Balance The sum of all unamortized
discounts, premiums, fees,
commissions, etc. Components of
the balance that amortize as a
gain (like discounts) should be
positive. Components that amortize
as a cost or as a loss (premiums,
fees, etc.) should be negative
------------------------------------------------------------------------
Unamortized Balance Scale Factor Factor determined by reconciling
reported Unamortized Balance to
published financials
------------------------------------------------------------------------
UPB Scale Factor Factor determined by reconciling
the reported current security
balance to published financials
------------------------------------------------------------------------
Security Rating The most current rating issued by
any Nationally Recognized
Statistical Rating Organization
(NRSRO) for this security, as of
the reporting date
------------------------------------------------------------------------
[c] Table 3-14, Inputs for MRBs and Derivative MBS Cash Flows
Inputs sets forth the data elements that the Enterprises must
compile in the RBC Report regarding mortgage revenue bonds and
private issue mortgage related securities (MRS). The data in this
table is supplemented with public securities disclosure data. This
information is necessary for determining associated cash flows in
the Stress Test.
Table 3-14--Inputs for MRBs and Derivative MBS Cash Flows Inputs
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
CUSIP Number A unique number assigned to
publicly traded securities by the
Committee on Uniform Securities
Identification Procedures
------------------------------------------------------------------------
Original Security Balance Original principal balance,
adjusted by UPB scale factor and
multiplied by the Enterprise's
percentage ownership
------------------------------------------------------------------------
Current Security Balance Initial Principal balance (at start
of Stress Period), adjusted by UPB
scale factor and multiplied by the
Enterprise's percentage ownership
------------------------------------------------------------------------
Unamortized Balance The sum of all unamortized
discounts, premiums, fees,
commissions, etc. adjusted by
Unamortized Balance scale factor
------------------------------------------------------------------------
Unamortized Balance Scale Factor Factor determined by reconciling
reported Unamortized Balance to
published financials
------------------------------------------------------------------------
UPB Scale Factor Factor determined by reconciling
the reported current security
balance to published financials
------------------------------------------------------------------------
Floating Rate Flag Indicates the instrument pays
interest at a floating rate
------------------------------------------------------------------------
Issue Date The issue date of the security
------------------------------------------------------------------------
Maturity Date The stated maturity date of the
security
------------------------------------------------------------------------
Security Interest Rate The rate at which the security
earns interest, as of the
reporting date
------------------------------------------------------------------------
Principal Payment Window Starting The month in the Stress Test that
Date, Down-Rate Scenario principal payment is expected to
start for the security under the
statutory ``down'' interest rate
scenario, according to Enterprise
projections
------------------------------------------------------------------------
Principal Payment Window Ending The month in the Stress Test that
Date, Down-Rate Scenario principal payment is expected to
end for the security under the
statutory ``down'' interest rate
scenario, according to Enterprise
projections
------------------------------------------------------------------------
Principal Payment Window Starting The month in the Stress Test that
Date, Up-Rate Scenario principal payment is expected to
start for the security under the
statutory ``up'' interest rate
scenario, according to Enterprise
projections
------------------------------------------------------------------------
Principal Payment Window Ending The month in the Stress Test that
Date, Up-Rate Scenario principal payment is expected to
end for the security under the
statutory ``up'' interest rate
scenario, according to Enterprise
projections
------------------------------------------------------------------------
Notional Flag Indicates if the amounts reported
in Original Security Balance and
Current Security Balance are
notional
------------------------------------------------------------------------
Security Rating The most current rating issued by
any Nationally Recognized
Statistical Rating Organization
(NRSRO) for this security, as of
the reporting date
------------------------------------------------------------------------
Security Rate Index If the rate on the security adjusts
over time, the index on which the
adjustment is based
------------------------------------------------------------------------
Security Rate Index Coefficient If the rate on the security adjusts
over time, the coefficient is the
number used to multiply by the
value of the index
------------------------------------------------------------------------
Security Rate Index Spread If the rate on the security adjusts
over time, the spread is added to
the value of the index multiplied
by the coefficient to determine
the new rate
------------------------------------------------------------------------
Security Rate Adjustment Frequency The number of months between rate
adjustments
------------------------------------------------------------------------
[[Page 47819]]
Security Interest Rate Ceiling The maximum rate (lifetime cap) on
the security
------------------------------------------------------------------------
Security Interest Rate Floor The minimum rate (lifetime floor)
on the security
------------------------------------------------------------------------
Life Ceiling Interest Rate The maximum interest rate allowed
throughout the life of the
security
------------------------------------------------------------------------
Life Floor Interest Rate The minimum interest rate allowed
throughout the life of security
------------------------------------------------------------------------
3.1.2.3 Nonmortgage Instrument Cash Flows Inputs
Table 3-15, Input Variables for Nonmortgage Instrument Cash
flows sets forth the data elements that the Enterprises must compile
in the RBC Report to identify individual securities (other than
Mortgage Related Securities) that are held by the Enterprises in
their portfolios. These include debt securities, preferred stock,
and derivative contracts (interest rate swaps, caps, and floors).
All data are instrument specific. The data in this table are
supplemented by public securities disclosure data. For instruments
with complex or non-standard features, the Enterprises may be
required to provide additional information such as amortization
schedules, interest rate coupon reset formulas, and the terms of the
call options.
Table 3-15--Input Variables for Nonmortgage Instrument Cash flows
------------------------------------------------------------------------
Data Elements Description
------------------------------------------------------------------------
Amortization Methodology Code Enterprise method of amortizing
deferred balances (e.g., straight
line)
------------------------------------------------------------------------
Asset ID CUSIP or Reference Pool Number
identifying the asset underlying a
derivative position
------------------------------------------------------------------------
Asset Type Code Code that identifies asset type
used in the commercial information
service (e.g. ABS, Fannie Mae
pool, Freddie Mac pool)
------------------------------------------------------------------------
Associated Instrument ID Instrument ID of an instrument
linked to another instrument
------------------------------------------------------------------------
Coefficient Indicates the extent to which the
coupon is leveraged or de-
leveraged
------------------------------------------------------------------------
Compound Indicator Indicates if interest is compounded
------------------------------------------------------------------------
Compounding Frequency Indicates how often interest is
compounded
------------------------------------------------------------------------
Counterparty Credit Rating NRSRO's rating for the counterparty
------------------------------------------------------------------------
Counterparty Credit Rating Type An indicator identifying the
counterparty's credit rating as
short-term (`S') or long-term
(`L')
------------------------------------------------------------------------
Counterparty ID Enterprise counterparty tracking ID
------------------------------------------------------------------------
Country Code Standard country codes in
compliance with Federal
Information Processing Standards
Publication 10-4
------------------------------------------------------------------------
Credit Agency Code Identifies NRSRO (e.g., Moody's)
------------------------------------------------------------------------
Current Asset Face Amount Current face amount of the asset
underlying a swap adjusted by UPB
scale factor
------------------------------------------------------------------------
Current Coupon Current coupon or dividend rate of
the instrument
------------------------------------------------------------------------
Current Unamortized Discount Current unamortized premium or
unaccreted discount of the
instrument adjusted by Unamortized
Balance scale factor
------------------------------------------------------------------------
Current Unamortized Fees Current unamortized fees associated
with the instrument adjusted by
Unamortized Balance scale factor
------------------------------------------------------------------------
Current Unamortized Hedge Current unamortized hedging gains
or losses associated with the
instrument adjusted by Unamortized
Balance scale factor
------------------------------------------------------------------------
Current Unamortized Other Any other unamortized items
originally associated with the
instrument adjusted by Unamortized
Balance scale factor
------------------------------------------------------------------------
CUSIP__ISIN CUSIP or ISIN Number identifying
the instrument
------------------------------------------------------------------------
Day Count Day count convention (e.g. 30/360)
------------------------------------------------------------------------
End Date The last index repricing date
------------------------------------------------------------------------
EOP Principal Balance End of Period face, principal or
notional, amount of the instrument
adjusted by UPB scale factor
------------------------------------------------------------------------
Exact Representation Indicates that an instrument is
modeled according to its
contractual terms
------------------------------------------------------------------------
Exercise Convention Indicates option exercise
convention (e.g., American Option)
------------------------------------------------------------------------
Exercise Price Par = 1.0; Options
------------------------------------------------------------------------
First Coupon Date Date first coupon is received or
paid
------------------------------------------------------------------------
Index Cap Indicates maximum index rate
------------------------------------------------------------------------
Index Floor Indicates minimum index rate
------------------------------------------------------------------------
Index Reset Frequency Indicates how often the interest
rate index resets on floating-rate
instruments
------------------------------------------------------------------------
Index Code Indicates the interest rate index
to which floating-rate instruments
are tied (e.g., LIBOR)
------------------------------------------------------------------------
[[Page 47820]]
Index Term Point on yield curve, expressed in
months, upon which the index is
based
------------------------------------------------------------------------
Instrument Credit Rating NRSRO credit rating for the
instrument
------------------------------------------------------------------------
Instrument Credit Rating Type An indicator identifying the
instruments credit rating as short-
term (`S') or long-term (`L')
------------------------------------------------------------------------
Instrument ID An integer used internally by the
Enterprise that uniquely
identifies the instrument
------------------------------------------------------------------------
Interest Currency Code Indicates currency in which
interest payments are paid or
received
------------------------------------------------------------------------
Interest Type Code Indicates the method of interest
rate payments (e.g., fixed,
floating, step, discount)
------------------------------------------------------------------------
Issue Date Indicates the date that the
instrument was issued
------------------------------------------------------------------------
Life Cap Rate The maximum interest rate for the
instrument throughout its life
------------------------------------------------------------------------
Life Floor Rate The minimum interest rate for the
instrument throughout its life
------------------------------------------------------------------------
Look-Back Period Period from the index reset date,
expressed in months, that the
index value is derived
------------------------------------------------------------------------
Maturity Date Date that the instrument
contractually matures
------------------------------------------------------------------------
Notional Indicator Identifies whether the face amount
is notional
------------------------------------------------------------------------
Instrument Type Code Indicates the type of instrument to
be modeled (e.g., ABS, Cap, Swap)
------------------------------------------------------------------------
Option Indicator Indicates if instrument contains an
option
------------------------------------------------------------------------
Option Type Indicates option type (e.g., Call
option)
------------------------------------------------------------------------
Original Asset Face Amount Original face amount of the asset
underlying a swap adjusted by UPB
scale factor
------------------------------------------------------------------------
Original Discount Original discount or premium amount
of the instrument adjusted by
Unamortized Balance scale factor
------------------------------------------------------------------------
Original Face Original face, principal or
notional, amount of the instrument
adjusted by UPB scale factor
------------------------------------------------------------------------
Original Fees Fees associated with the instrument
at inception adjusted by
Unamortized Balance scale factor
------------------------------------------------------------------------
Original Hedge Hedging gain or loss to be
amortized or accreted at inception
adjusted by Unamortized Balance
scale factor
------------------------------------------------------------------------
Original Other Any other amounts originally
associated with the instrument to
be amortized or accreted adjusted
by Unamortized Balance scale
factor
------------------------------------------------------------------------
Parent Entity ID Enterprise internal tracking ID for
parent entity
------------------------------------------------------------------------
Payment Amount Interest payment amount associated
with the instrument (reserved for
complex instruments where interest
payments are not modeled) adjusted
by UPB scale factor
------------------------------------------------------------------------
Payment Frequency Indicates how often interest
payments are made or received
------------------------------------------------------------------------
Performance Date ``As of'' date on which the data is
submitted
------------------------------------------------------------------------
Periodic Adjustment The maximum amount that the
interest rate for the instrument
can change per reset
------------------------------------------------------------------------
Position Code Indicates whether the Enterprise
pays or receives interest on the
instrument
------------------------------------------------------------------------
Principal Currency Code Indicates currency in which
principal payments are paid or
received
------------------------------------------------------------------------
Principal Factor Amount EOP Principal Balance expressed as
a percentage of Original Face
------------------------------------------------------------------------
Principal Payment Date A valid date identifying the date
that principal is paid
------------------------------------------------------------------------
Settlement Date A valid date identifying the date
the settlement occurred
------------------------------------------------------------------------
Spread An amount added to an index to
determine an instrument's interest
rate
------------------------------------------------------------------------
Start Date The date, spot or forward, when
some feature of a financial
contract becomes effective (e.g.,
Call Date), or when interest
payments or receipts begin to be
calculated
------------------------------------------------------------------------
Strike Rate The price or rate at which an
option begins to have a settlement
value at expiration, or, for
interest-rate caps and floors, the
rate that triggers interest
payments
------------------------------------------------------------------------
Submitting Entity Indicates which Enterprise is
submitting information
------------------------------------------------------------------------
Trade ID Unique code identifying the trade
of an instrument
------------------------------------------------------------------------
Transaction Code Indicates the transaction that an
Enterprise is initiating with the
instrument (e.g. buy, issue
reopen)
------------------------------------------------------------------------
Transaction Date A valid date identifying the date
the transaction occurred
------------------------------------------------------------------------
UPB Scale Factor Factor determined by reconciling
reported UPB to published
financials
------------------------------------------------------------------------
[[Page 47821]]
Unamortized Balances Scale Factor Factor determined by reconciling
reported Unamortized Balances to
published financials
------------------------------------------------------------------------
3.1.2.4 Inputs for Alternative Modeling Treatment Items
Table 3-16--Inputs for Alternative Modeling Treatment Items
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
TYPE Type of item (asset, liability or
off-balance sheet item)
------------------------------------------------------------------------
BOOK Book Value of item (amount
outstanding adjusted for deferred
items)
------------------------------------------------------------------------
FACE Face Value or notional balance of
item for off-balance sheet items
------------------------------------------------------------------------
REMATUR Remaining Contractual Maturity of
item in whole months. Any fraction
of a month equals one whole month
------------------------------------------------------------------------
RATE Interest Rate
------------------------------------------------------------------------
INDEX Index used to calculate Interest
Rate
------------------------------------------------------------------------
FAS115 Designation that the item is
recorded at fair value, according
to FAS 115
------------------------------------------------------------------------
RATING Instrument or counterparty rating
------------------------------------------------------------------------
FHA In the case of off-balance sheet
guarantees, a designation
indicating 100% of collateral is
guaranteed by FHA
------------------------------------------------------------------------
UABAL Unamortized Balance (Book minus
Face)
------------------------------------------------------------------------
MARGIN Margin over an Index
------------------------------------------------------------------------
3.1.2.5 Operations, Taxes, and Accounting Inputs
[a] Table 3-17, Operations, Taxes, and Accounting Inputs sets
forth the data the Enterprises must compile in the RBC Report to
permit the calculation of taxes, operating expenses, and dividends.
These data include:
Average monthly Operating Expenses (i.e., administrative
expenses, salaries and benefits, professional services, property
costs, equipment costs) for the quarter prior to the beginning of
the Stress Test;
Income for the current year-to-date, one year, and two
years prior to the beginning of the stress test, before taxes and
provision for income taxes;
Dividend payout ratio for the four quarters prior to the
beginning of the Stress Period;
Minimum capital requirement as of the beginning of the
Stress Period.
Table 3-17--Operations, Taxes, and Accounting Inputs
------------------------------------------------------------------------
Input Description
------------------------------------------------------------------------
FAS 115 and 125 fair value
adjustment on retained mortgage
portfolio
------------------------------------------------------------------------
FAS 133 fair value adjustment on
retained mortgage portfolio
------------------------------------------------------------------------
Reserve for losses on retained
mortgage portfolio
------------------------------------------------------------------------
FAS 115 and 125 fair value
adjustments on non-mortgage
investments
------------------------------------------------------------------------
FAS 133 fair value adjustments on
non-mortgage investments
------------------------------------------------------------------------
Total cash
------------------------------------------------------------------------
Accrued interest receivable on
mortgages
------------------------------------------------------------------------
Accrued interest receivable on non-
mortgage investment securities
------------------------------------------------------------------------
Accrued interest receivable on non-
mortgage investment securities
denominated in foreign currency--
hedged
------------------------------------------------------------------------
Accrued interest receivable on non-
mortgage investment securities
denominated in foreign currency--
unhedged
------------------------------------------------------------------------
Accrued interest receivable on
mortgage-linked derivatives, gross
------------------------------------------------------------------------
Accrued interest receivable on
investment-linked derivatives,
gross
------------------------------------------------------------------------
Accrued interest receivable on debt-
linked derivatives, gross
------------------------------------------------------------------------
Other accrued interest receivable
------------------------------------------------------------------------
Accrued interest receivable on Underlying instrument is GSE issued
hedged debt-linked foreign debt
currency swaps
------------------------------------------------------------------------
Accrued interest receivable on
unhedged debt-linked foreign
currency swaps
------------------------------------------------------------------------
[[Page 47822]]
Accrued interest receivable on Underlying instrument is an asset
hedged asset-linked foreign
currency swaps
------------------------------------------------------------------------
Accrued interest receivable on
unhedged asset-linked foreign
currency swaps
------------------------------------------------------------------------
Currency transaction adjustments-- Cumulative gain or loss due to
hedged assets changes in foreign exchange rates
relative to on-balance sheet
assets originally denominated in
foreign currency
------------------------------------------------------------------------
Currency transaction adjustments-- Cumulative gain or loss due to
unhedged assets changes in foreign exchange rates
relative to unhedged assets and
off-balance sheet items originally
denominated in foreign currency
------------------------------------------------------------------------
Federal income tax refundable
------------------------------------------------------------------------
Accounts receivable
------------------------------------------------------------------------
Fees receivable
------------------------------------------------------------------------
Low income housing tax credit
investments
------------------------------------------------------------------------
Fixed assets, net
------------------------------------------------------------------------
Clearing accounts Net book value of all clearing
accounts
------------------------------------------------------------------------
Other assets
------------------------------------------------------------------------
Foreclosed property, net Real estate owned including
property acquired through
foreclosure proceedings
------------------------------------------------------------------------
FAS 133 fair value adjustment on
debt securities
------------------------------------------------------------------------
Accrued interest payable on
existing fixed-rate debt
securities
------------------------------------------------------------------------
Accrued interest payable on
existing floating-rate debt
securities
------------------------------------------------------------------------
Accrued interest payable on
existing debt issued in foreign
currency--hedged
------------------------------------------------------------------------
Accrued interest payable on
existing debt issued in foreign
currency--unhedged
------------------------------------------------------------------------
Accrued interest payable on
mortgage-linked derivatives, gross
------------------------------------------------------------------------
Accrued interest payable on
investment-linked derivatives,
gross
------------------------------------------------------------------------
Accrued interest payable on debt-
linked derivatives, gross
------------------------------------------------------------------------
Other accrued interest payable
------------------------------------------------------------------------
Accrued interest payable debt-
linked foreign currency swaps--
hedged
------------------------------------------------------------------------
Accrued interest payable debt-
linked foreign currency swaps--
unhedged
------------------------------------------------------------------------
Accrued interest payable asset-
linked foreign currency swaps--
hedged
------------------------------------------------------------------------
Accrued interest payable asset-
linked foreign currency swaps--
unhedged
------------------------------------------------------------------------
Principal and interest due to Cash received on sold mortgages for
mortgage security investors onward submission to mortgage
security investors
------------------------------------------------------------------------
Currency transaction adjustments-- Cumulative gain or loss due to
hedged debt changes in foreign exchange rates
relative to on-balance sheet debt
originally denominated in foreign
currency
------------------------------------------------------------------------
Currency transaction adjustments-- Cumulative gain or loss due to
unhedged debt changes in foreign exchange rates
relative to unhedged liabilities
and off-balance sheet items
originally denominated in foreign
currency
------------------------------------------------------------------------
Escrow deposits Cash balances held in relation to
servicing of multi-family loans
------------------------------------------------------------------------
Federal income taxes payable
------------------------------------------------------------------------
Preferred dividends payable
------------------------------------------------------------------------
Accounts payable
------------------------------------------------------------------------
Other liabilities
------------------------------------------------------------------------
Common dividends payable
------------------------------------------------------------------------
Reserve for losses on sold
mortgages
------------------------------------------------------------------------
Common stock
------------------------------------------------------------------------
Preferred stock, non-cumulative
------------------------------------------------------------------------
Additional paid-in capital
------------------------------------------------------------------------
[[Page 47823]]
Retained earnings
------------------------------------------------------------------------
Treasury stock
------------------------------------------------------------------------
Unrealized gains and losses on
available-for-sale securities, net
of tax, in accordance with FAS 115
and 125
------------------------------------------------------------------------
Unrealized gains and losses due to
mark to market adjustments, FAS
115 and 125
------------------------------------------------------------------------
Unrealized gains and losses due to
deferred balances related to pre-
FAS 115 and 125 adjustments
------------------------------------------------------------------------
Unrealized gains and losses due to
other realized gains, FAS 115
------------------------------------------------------------------------
Other comprehensive income, net of
tax, in accordance with FAS 133
------------------------------------------------------------------------
OCI due to mark to market
adjustments, FAS 133
------------------------------------------------------------------------
OCI due to deferred balances
related to pre-FAS 133 adjustments
------------------------------------------------------------------------
OCI due to other realized gains,
FAS 133
------------------------------------------------------------------------
Operating expenses Average of prior three months
------------------------------------------------------------------------
Common dividend payout ratio Sum dollar amount of common
(average of prior 4 quarters) dividends paid over prior 4
quarters and divided by the sum of
total of after tax income less
preferred dividends paid over
prior 4 quarters
------------------------------------------------------------------------
Common dividends per share paid 1
quarter prior to the beginning of
the stress period
------------------------------------------------------------------------
Common shares outstanding
------------------------------------------------------------------------
Common Share Market Price
------------------------------------------------------------------------
Dividends paid on common stock 1
quarter prior to the beginning of
the stress period
------------------------------------------------------------------------
Share Repurchases (average of prior Sum dollar amount of repurchased
4 quarters) shares, net of newly issued
shares, over prior 4 quarters and
divided by 4
------------------------------------------------------------------------
Off-balance-sheet Guarantees Guaranteed instruments not reported
on the balance sheet, such as
whole loan REMICs and multifamily
credit enhancements, and not 100%
guaranteed by the FHA
------------------------------------------------------------------------
Other Off-Balance Sheet Guarantees All other off-balance sheet
guaranteed instruments not
included in another category, and
not 100% guaranteed by the FHA
------------------------------------------------------------------------
YTD provision for income taxes Provision for income taxes for the
period beginning January 1 and
ending as of the report date
------------------------------------------------------------------------
Tax loss carryforward Net losses available to write off
against future years' net income
------------------------------------------------------------------------
Tax liability for the year prior to
the beginning of the Stress Test
------------------------------------------------------------------------
Tax liability for the year 2 years
prior to the beginning of the
Stress Test (net of carrybacks)
------------------------------------------------------------------------
Taxable income for the year prior
to the beginning of the Stress
Test
------------------------------------------------------------------------
Taxable income for the year 2 years
prior to the beginning of the
Stress Test (net of carrybacks)
------------------------------------------------------------------------
Net after tax income for the
quarter preceding the start of the
stress test
------------------------------------------------------------------------
YTD taxable income Total amount of taxable income for
the period beginning January 1 and
ending as of the report date
------------------------------------------------------------------------
Minimum capital requirement at the
beginning of the Stress Period
------------------------------------------------------------------------
Specific allowance for loan losses Loss allowances calculated in
accordance with FAS 114
------------------------------------------------------------------------
Zero coupon swap receivable
------------------------------------------------------------------------
Unamortized discount on zero coupon
swap receivable
------------------------------------------------------------------------
[[Page 47824]]
3.1.3 Public Data
3.1.3.1 Interest Rates
[a] The Interest Rates component of the Stress Test projects
Treasury yields as well as other interest rate indexes that are
needed to calculate cash flows, to simulate the performance of
mortgages and other financial instruments, and to calculate capital
for each of the 120 months in the Stress Period. Table 3-18,
Interest Rate and Index Inputs, sets forth the interest rate indexes
used in the Stress Test
[b] The starting values for all of the Interest Rates are the
monthly average of daily rates for the month preceding the start of
the stress test.
[c] For the 10-year CMT, monthly values are required for the
three years prior to the start of the Stress Test (m = -35,
-34...0). For all other indexes, monthly values for the prior two
years are required (m = -23, -22...0).
Table 3-18--Interest Rate and Index Inputs
----------------------------------------------------------------------------------------------------------------
Interest Rate Index Description Source
----------------------------------------------------------------------------------------------------------------
1 MO Treasury Bill One-month Treasury bill yield, Bloomberg Generic 1 Month
monthly simple average of daily U.S. Treasury bill,
rate, quoted as actual/360 Ticker: GB1M (index)
----------------------------------------------------------------------------------------------------------------
3 MO CMT Three-month constant maturity Federal Reserve H.15 Release
Treasury yield, monthly simple
average of daily rate, quoted as
bond equivalent yield
----------------------------------------------------------------------------------------------------------------
6 MO CMT Six-month constant maturity Treasury Federal Reserve H.15 Release
yield, monthly simple average of
daily rate, quoted as bond
equivalent yield
----------------------------------------------------------------------------------------------------------------
1 YR CMT One-year constant maturity Treasury Federal Reserve H.15 Release
yield, monthly simple average of
daily rate, quoted as bond
equivalent yield
----------------------------------------------------------------------------------------------------------------
2 YR CMT Two-year constant maturity Treasury Federal Reserve H.15 Release
yield, monthly simple average of
daily rate, quoted as bond
equivalent yield
----------------------------------------------------------------------------------------------------------------
3 YR CMT Three-year constant maturity Federal Reserve H.15 Release
Treasury yield, monthly simple
average of daily rate, quoted as
bond equivalent yield
----------------------------------------------------------------------------------------------------------------
5 YR CMT Five-year constant maturity Treasury Federal Reserve H.15 Release
yield, monthly simple average of
daily rate, quoted as bond
equivalent yield
----------------------------------------------------------------------------------------------------------------
10 YR CMT Ten-year constant maturity Treasury Federal Reserve H.15 Release
yield, monthly simple average of
daily rate, quoted as bond
equivalent yield
----------------------------------------------------------------------------------------------------------------
20 YR CMT Twenty-year constant maturity Federal Reserve H.15 Release
Treasury yield, monthly simple
average of daily rate, quoted as
bond equivalent yield
----------------------------------------------------------------------------------------------------------------
30 YR CMT Thirty-year constant maturity Federal Reserve H.15 Release
Treasury yield, monthly simple
average of daily rate, quoted as
bond equivalent yield
----------------------------------------------------------------------------------------------------------------
Overnight Fed Funds (Effective) Overnight effective Federal Funds Federal Reserve H.15 Release
rate, monthly simple average of
daily rate
----------------------------------------------------------------------------------------------------------------
1 Week Federal Funds 1 week Federal Funds rate, monthly Bloomberg Term Fed Funds U.S.
simple average of daily rates Domestic,
Ticker: FFTD01W (index)
----------------------------------------------------------------------------------------------------------------
6 Month Fed Funds 6 month Federal Funds rate, monthly Bloomberg Term Fed Funds U.S.
simple average of daily rates Domestic,
Ticker: FFTD06M (index)
----------------------------------------------------------------------------------------------------------------
Conventional Mortgage Rate FHLMC (Freddie Mac) contract Federal Reserve H.15 Release
interest rates for 30 YR fixed-rate
mortgage commitments, monthly
average of weekly rates
----------------------------------------------------------------------------------------------------------------
FHLB 11th District COF 11th District (San Francisco) Bloomberg Cost of Funds for the 11th
weighted average cost of funds for District
savings and loans, monthly Ticker: COF11 (index)
----------------------------------------------------------------------------------------------------------------
1 MO LIBOR One-month London Interbank Offered British Bankers Association
Rate, average of bid and asked, Bloomberg Ticker: US0001M (index)
monthly simple average of daily
rates, quoted as actual/360
----------------------------------------------------------------------------------------------------------------
3 MO LIBOR Three-month London Interbank Offered British Bankers Association
Rate, average of bid and asked, Bloomberg Ticker: US0003M (index)
monthly simple average of daily
rates, quoted as actual/360
----------------------------------------------------------------------------------------------------------------
6 MO LIBOR Six-month London Interbank Offered British Bankers Association
Rate, average of bid and asked, Bloomberg Ticker: US0006M (index)
monthly simple average of daily
rates, quoted as actual/360
----------------------------------------------------------------------------------------------------------------
12 MO LIBOR One-year London Interbank Offered British Bankers Association
Rate, average of bid and asked, Bloomberg Ticker: US0012M (index)
monthly simple average of daily
rates, quoted as actual/360
----------------------------------------------------------------------------------------------------------------
Prime Rate Prevailing rate as quoted, monthly Federal Reserve H.15 Release
average of daily rates
----------------------------------------------------------------------------------------------------------------
1 MO Federal Agency COF One-month Federal Agency Cost of Bloomberg Generic 1 Month Agency
Funds, monthly simple average of Discount Note Yield
daily rates, quoted as actual/360 Ticker: AGDN030Y (index)
----------------------------------------------------------------------------------------------------------------
3 MO Federal Agency COF Three-month Federal Agency Cost of Bloomberg Generic 3 Month Agency
Funds, monthly simple average of Discount Note Yield
daily rates, quoted as actual/360 Ticker: AGDN090Y (index)
----------------------------------------------------------------------------------------------------------------
6 MO Federal Agency COF Six-month Federal Agency Cost of Bloomberg Generic 6 Month Agency
Funds, monthly simple average of Discount Note Yield
daily rates, quoted as actual/360 Ticker: AGDN180Y (index)
----------------------------------------------------------------------------------------------------------------
[[Page 47825]]
1 YR Federal Agency COF One-year Federal Agency Cost of Bloomberg Generic 12 Month Agency
Funds, monthly simple average of Discount Note Yield
daily rates, quoted as actual/360 Ticker: AGDN360Y (index)
----------------------------------------------------------------------------------------------------------------
2 YR Federal Agency COF Two-year Federal Agency Fair Market Bloomberg Generic 2 Year Agency Fair
Yield, monthly simple average of Market Yield
daily rates Ticker: AGAC02 (index)
----------------------------------------------------------------------------------------------------------------
3 YR Federal Agency COF Three-year Federal Agency Fair Bloomberg Generic 3 Year Agency Fair
Market Yield, monthly simple Market Yield
average of daily rates Ticker: AGAC03 (index)
----------------------------------------------------------------------------------------------------------------
5 YR Federal Agency COF Five-year Federal Agency Fair Market Bloomberg Generic 5 Year Agency Fair
Yield, monthly simple average of Market Yield
daily rates Ticker: AGAC05 (index)
----------------------------------------------------------------------------------------------------------------
10 YR Federal Agency COF Ten-year Federal Agency Fair Market Bloomberg Generic 10 Year Agency
Yield, monthly simple average of Fair Market Yield
daily rates Ticker: AGAC10 (index)
----------------------------------------------------------------------------------------------------------------
30 YR Federal Agency COF Thirty-year Federal Agency Fair Bloomberg Generic 30 Year Agency
Market Yield, monthly simple Fair Market Yield
average of daily rates Ticker: AGAC30 (index)
----------------------------------------------------------------------------------------------------------------
15 YR fixed-rate mortgage FHLMC (Freddie Mac) contract Bloomberg FHLMC 15 YR, 10 day
interest rates for 15 YR fixed-rate commitment rate
mortgage commitments, monthly Ticker: FHCR1510 (index)
average of FHLMC (Freddie Mac)
contract interest rates for 15 YR
----------------------------------------------------------------------------------------------------------------
7-year balloon mortgage rate Seven-year balloon mortgage, equal Computed
to the Conventional Mortgage Rate
less 50 basis points
----------------------------------------------------------------------------------------------------------------
3.1.3.2 Property Valuation Inputs
Table 3-19, Stress Test Single Family Quarterly House Price
Growth Rates and Table 3-21, HPI Dispersion Parameters, set forth
inputs which are used to project single family mortgage performance.
Table 3-20, Multifamily Monthly Rent Growth and Vacancy Rates, sets
forth inputs which are used to project multifamily mortgage
performance.
Table 3-19--Stress Test Single Family Quarterly House Price Growth Rates \1\
----------------------------------------------------------------------------------------------------------------
House Price House Price
Stress Test Months Historical Months Growth Rate Stress Test Months Historical Months Growth Rate
----------------------------------------------------------------------------------------------------------------
1-3 Jan-Mar 1984 -0.005048 61-63 Jan-Mar 1989 0.006292
----------------------------------------------------------------------------------------------------------------
4-6 Apr-Jun 1984 0.001146 64-66 Apr-Jun 1989 0.010523
----------------------------------------------------------------------------------------------------------------
7-9 Jul-Sep 1984 0.001708 67-69 Jul-Sep 1989 0.017893
----------------------------------------------------------------------------------------------------------------
10-12 Oct-Dec 1984 -0.007835 70-72 Oct-Dec 1989 -0.004881
----------------------------------------------------------------------------------------------------------------
13-15 Jan-Mar 1985 -0.006975 73-75 Jan-Mar 1990 -0.000227
----------------------------------------------------------------------------------------------------------------
16-18 Apr-Jun 1985 0.004178 76-78 Apr-Jun 1990 0.008804
----------------------------------------------------------------------------------------------------------------
19-21 Jul-Sep 1985 -0.005937 79-81 Jul-Sep 1990 0.003441
----------------------------------------------------------------------------------------------------------------
22-24 Oct-Dec 1985 -0.019422 82-84 Oct-Dec 1990 -0.003777
----------------------------------------------------------------------------------------------------------------
25-27 Jan-Mar 1986 0.026231 85-87 Jan-Mar 1991 0.009952
----------------------------------------------------------------------------------------------------------------
28-30 Apr-Jun 1986 0.022851 88-90 Apr-Jun 1991 0.012616
----------------------------------------------------------------------------------------------------------------
31-33 Jul-Sep 1986 -0.021402 91-93 Jul-Sep 1991 0.002267
----------------------------------------------------------------------------------------------------------------
34-36 Oct-Dec 1986 -0.018507 94-96 Oct-Dec 1991 0.012522
----------------------------------------------------------------------------------------------------------------
37-39 Jan-Mar 1987 0.004558 97-99 Jan-Mar 1992 0.013378
----------------------------------------------------------------------------------------------------------------
40-42 Apr-Jun 1987 -0.039306 100-102 Apr-Jun 1992 -0.000519
----------------------------------------------------------------------------------------------------------------
43-45 Jul-Sep 1987 -0.024382 103-105 Jul-Sep 1992 0.016035
----------------------------------------------------------------------------------------------------------------
46-48 Oct-Dec 1987 -0.026761 106-108 Oct-Dec 1992 0.005691
----------------------------------------------------------------------------------------------------------------
49-51 Jan-Mar 1988 -0.003182 109-111 Jan-Mar 1993 0.005723
----------------------------------------------------------------------------------------------------------------
52-54 Apr-Jun 1988 0.011854 112-114 Apr-Jun 1993 0.010614
----------------------------------------------------------------------------------------------------------------
55-57 Jul-Sep 1988 -0.020488 115-117 Jul-Sep 1993 0.013919
----------------------------------------------------------------------------------------------------------------
58-60 Oct-Dec 1988 -0.007260 118-120 Oct-Dec 1993 0.011267
----------------------------------------------------------------------------------------------------------------
\1\ Source: OFHEO House Price Report, 1996:3.
[[Page 47826]]
Table 3-20--Multifamily Monthly Rent Growth \1\ and Vacancy Rates \2\
--------------------------------------------------------------------------------------------------------------------------------------------------------
Rent Growth Vacancy Rent Growth Vacancy
Stress Test Month Historical Month Rate Rate Stress Test Month Historical Month Rate Rate
--------------------------------------------------------------------------------------------------------------------------------------------------------
1 Jan 1984 0.001367 0.136 61 Jan 1989 0.000052 0.135
--------------------------------------------------------------------------------------------------------------------------------------------------------
2 Feb 1984 0.001186 0.136 62 Feb 1989 0.000284 0.135
--------------------------------------------------------------------------------------------------------------------------------------------------------
3 Mar 1984 0.001422 0.136 63 Mar 1989 0.000404 0.135
--------------------------------------------------------------------------------------------------------------------------------------------------------
4 Apr 1984 0.001723 0.136 64 Apr 1989 0.000150 0.135
--------------------------------------------------------------------------------------------------------------------------------------------------------
5 May 1984 0.001537 0.136 65 May 1989 0.000331 0.135
--------------------------------------------------------------------------------------------------------------------------------------------------------
6 Jun 1984 0.001354 0.136 66 Jun 1989 0.001483 0.135
--------------------------------------------------------------------------------------------------------------------------------------------------------
7 Jul 1984 0.000961 0.136 67 Jul 1989 0.000759 0.135
--------------------------------------------------------------------------------------------------------------------------------------------------------
8 Aug 1984 0.000601 0.136 68 Aug 1989 0.001502 0.135
--------------------------------------------------------------------------------------------------------------------------------------------------------
9 Sep 1984 0.001106 0.136 69 Sep 1989 0.002254 0.135
--------------------------------------------------------------------------------------------------------------------------------------------------------
10 Oct 1984 0.001623 0.136 70 Oct 1989 0.002768 0.135
--------------------------------------------------------------------------------------------------------------------------------------------------------
11 Nov 1984 0.001395 0.136 71 Nov 1989 0.002220 0.135
--------------------------------------------------------------------------------------------------------------------------------------------------------
12 Dec 1984 0.001170 0.136 72 Dec 1989 0.002040 0.135
--------------------------------------------------------------------------------------------------------------------------------------------------------
13 Jan 1985 0.001014 0.150 73 Jan 1990 0.002180 0.120
--------------------------------------------------------------------------------------------------------------------------------------------------------
14 Feb 1985 0.000857 0.150 74 Feb 1990 0.002772 0.120
--------------------------------------------------------------------------------------------------------------------------------------------------------
15 Mar 1985 0.000315 0.150 75 Mar 1990 0.002867 0.120
--------------------------------------------------------------------------------------------------------------------------------------------------------
16 Apr 1985 -0.000225 0.150 76 Apr 1990 0.003243 0.120
--------------------------------------------------------------------------------------------------------------------------------------------------------
17 May 1985 0.000154 0.150 77 May 1990 0.002963 0.120
--------------------------------------------------------------------------------------------------------------------------------------------------------
18 Jun 1985 0.000534 0.150 78 Jun 1990 0.003588 0.120
--------------------------------------------------------------------------------------------------------------------------------------------------------
19 Jul 1985 0.001115 0.150 79 Jul 1990 0.004885 0.120
--------------------------------------------------------------------------------------------------------------------------------------------------------
20 Aug 1985 0.001702 0.150 80 Aug 1990 0.004564 0.120
--------------------------------------------------------------------------------------------------------------------------------------------------------
21 Sep 1985 0.001576 0.150 81 Sep 1990 0.005491 0.120
--------------------------------------------------------------------------------------------------------------------------------------------------------
22 Oct 1985 0.001450 0.150 82 Oct 1990 0.005475 0.120
--------------------------------------------------------------------------------------------------------------------------------------------------------
23 Nov 1985 0.001357 0.150 83 Nov 1990 0.005763 0.120
--------------------------------------------------------------------------------------------------------------------------------------------------------
24 Dec 1985 0.001266 0.150 84 Dec 1990 0.005817 0.120
--------------------------------------------------------------------------------------------------------------------------------------------------------
25 Jan 1986 0.001823 0.168 85 Jan 1991 0.005261 0.108
--------------------------------------------------------------------------------------------------------------------------------------------------------
26 Feb 1986 0.002392 0.168 86 Feb 1991 0.005456 0.108
--------------------------------------------------------------------------------------------------------------------------------------------------------
27 Mar 1986 0.002665 0.168 87 Mar 1991 0.005637 0.108
--------------------------------------------------------------------------------------------------------------------------------------------------------
28 Apr 1986 0.002942 0.168 88 Apr 1991 0.005843 0.108
--------------------------------------------------------------------------------------------------------------------------------------------------------
29 May 1986 0.002517 0.168 89 May 1991 0.005970 0.108
--------------------------------------------------------------------------------------------------------------------------------------------------------
30 Jun 1986 0.002105 0.168 90 Jun 1991 0.005719 0.108
--------------------------------------------------------------------------------------------------------------------------------------------------------
31 Jul 1986 0.001372 0.168 91 Jul 1991 0.005533 0.108
--------------------------------------------------------------------------------------------------------------------------------------------------------
32 Aug 1986 0.000652 0.168 92 Aug 1991 0.004512 0.108
--------------------------------------------------------------------------------------------------------------------------------------------------------
33 Sep 1986 0.000110 0.168 93 Sep 1991 0.003916 0.108
--------------------------------------------------------------------------------------------------------------------------------------------------------
34 Oct 1986 -0.000431 0.168 94 Oct 1991 0.003779 0.108
--------------------------------------------------------------------------------------------------------------------------------------------------------
35 Nov 1986 -0.000201 0.168 95 Nov 1991 0.004226 0.108
--------------------------------------------------------------------------------------------------------------------------------------------------------
36 Dec 1986 0.000030 0.168 96 Dec 1991 0.004791 0.108
--------------------------------------------------------------------------------------------------------------------------------------------------------
37 Jan 1987 -0.001448 0.175 97 Jan 1992 0.005361 0.098
--------------------------------------------------------------------------------------------------------------------------------------------------------
38 Feb 1987 -0.002162 0.175 98 Feb 1992 0.004085 0.098
--------------------------------------------------------------------------------------------------------------------------------------------------------
39 Mar 1987 -0.001202 0.175 99 Mar 1992 0.003885 0.098
--------------------------------------------------------------------------------------------------------------------------------------------------------
40 Apr 1987 -0.001136 0.175 100 Apr 1992 0.002992 0.098
--------------------------------------------------------------------------------------------------------------------------------------------------------
41 May 1987 -0.001466 0.175 101 May 1992 0.002941 0.098
--------------------------------------------------------------------------------------------------------------------------------------------------------
[[Page 47827]]
42 Jun 1987 -0.002809 0.175 102 Jun 1992 0.002851 0.098
--------------------------------------------------------------------------------------------------------------------------------------------------------
43 Jul 1987 -0.002069 0.175 103 Jul 1992 0.002346 0.098
--------------------------------------------------------------------------------------------------------------------------------------------------------
44 Aug 1987 -0.002530 0.175 104 Aug 1992 0.003850 0.098
--------------------------------------------------------------------------------------------------------------------------------------------------------
45 Sep 1987 -0.001033 0.175 105 Sep 1992 0.003245 0.098
--------------------------------------------------------------------------------------------------------------------------------------------------------
46 Oct 1987 -0.001148 0.175 106 Oct 1992 0.003194 0.098
--------------------------------------------------------------------------------------------------------------------------------------------------------
47 Nov 1987 -0.001617 0.175 107 Nov 1992 0.001931 0.098
--------------------------------------------------------------------------------------------------------------------------------------------------------
48 Dec 1987 -0.002064 0.175 108 Dec 1992 0.001494 0.098
--------------------------------------------------------------------------------------------------------------------------------------------------------
49 Jan 1988 -0.001372 0.158 109 Jan 1993 0.001527 0.104
--------------------------------------------------------------------------------------------------------------------------------------------------------
50 Feb 1988 -0.001524 0.158 110 Feb 1993 0.002317 0.104
--------------------------------------------------------------------------------------------------------------------------------------------------------
51 Mar 1988 -0.001972 0.158 111 Mar 1993 0.001904 0.104
--------------------------------------------------------------------------------------------------------------------------------------------------------
52 Apr 1988 -0.001363 0.158 112 Apr 1993 0.002545 0.104
--------------------------------------------------------------------------------------------------------------------------------------------------------
53 May 1988 -0.001143 0.158 113 May 1993 0.002570 0.104
--------------------------------------------------------------------------------------------------------------------------------------------------------
54 Jun 1988 -0.001194 0.158 114 Jun 1993 0.002449 0.104
--------------------------------------------------------------------------------------------------------------------------------------------------------
55 Jul 1988 -0.001429 0.158 115 Jul 1993 0.002161 0.104
--------------------------------------------------------------------------------------------------------------------------------------------------------
56 Aug 1988 -0.001315 0.158 116 Aug 1993 0.001857 0.104
--------------------------------------------------------------------------------------------------------------------------------------------------------
57 Sep 1988 -0.002581 0.158 117 Sep 1993 0.001664 0.104
--------------------------------------------------------------------------------------------------------------------------------------------------------
58 Oct 1988 -0.002337 0.158 118 Oct 1993 0.002184 0.104
--------------------------------------------------------------------------------------------------------------------------------------------------------
59 Nov 1988 -0.001218 0.158 119 Nov 1993 0.002932 0.104
--------------------------------------------------------------------------------------------------------------------------------------------------------
60 Dec 1988 -0.000203 0.158 120 Dec 1993 0.002776 0.104
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Source: U.S. Department of Labor, Bureau of Labor Statistics, Rent of Primary Residence component of the Consumer Price Index--All Urban Consumers.
\2\ Source: U.S. Census Bureau, Housing Vacancy Survey--Annual 1999.
Table 3-21--HPI Dispersion Parameters \1\
------------------------------------------------------------------------
Linear () ()
------------------------------------------------------------------------
Dispersion Parameter 0.002977 -0.000024322
------------------------------------------------------------------------
\1\ Source: OFHEO House Price Report, 1996:3.
3.1.4 Constant Values
Certain values are numerical constants that are parameters of
the cash flow simulation. These values are established by OFHEO on
the basis of analysis of Benchmark and other historical data.
3.1.4.1 Single Family Loan Performance
Table 3-22--Loan Group Inputs for Single Family Gross Loss Severity
----------------------------------------------------------------------------------------------------------------
Variable Description Value Source
----------------------------------------------------------------------------------------------------------------
MQ Months Delinquent: time 4 for sold loans
during which Enterprise 0 otherwise
pays delinquent loan
interest to MBS holders
----------------------------------------------------------------------------------------------------------------
MF Months to Foreclosure: 13 months Average value of BLE data
number of missed
payments through
completion of
foreclosure
----------------------------------------------------------------------------------------------------------------
MR Months in REO 7 months Average value of BLE data
----------------------------------------------------------------------------------------------------------------
F Foreclosure Costs as a 0.037 Average of historical
decimal fraction of data from Enterprise
Defaulted UPB loans, 1979-1999
----------------------------------------------------------------------------------------------------------------
R REO Expenses as a decimal 0.163 Average of historical
fraction of Defaulted data from Enterprise
UPB loans, 1979-1999
----------------------------------------------------------------------------------------------------------------
[[Page 47828]]
RR Recovery Rate for 0.61 Average value of BLE data
Defaulted loans in the
BLE, as a percent of
predicted house price
using HPI (decimal)
----------------------------------------------------------------------------------------------------------------
See also Table 3-35, Coefficients for Single Family Default and
Prepayment Explanatory Variables.
3.1.4.2 Multifamily Loan Performance
Table 3-23--Loan Group Inputs for Multifamily Default and Prepayment
----------------------------------------------------------------------------------------------------------------
Variable Description Value Source
----------------------------------------------------------------------------------------------------------------
OE Operating expenses as a 0.472 Average ratio of operating
share of gross potential expenses to gross rents,
rents 1970-1992 Institute for
Real Estate Management
annual surveys of
apartments.
----------------------------------------------------------------------------------------------------------------
RVRo Initial rental vacancy rate 0.0623 National average vacancy
rate, 1970-1995, from
census surveys.
----------------------------------------------------------------------------------------------------------------
Table 3-24--Loan Group Inputs for Multifamily Gross Loss Severity
----------------------------------------------------------------------------------------------------------------
Variable Description Value Source
----------------------------------------------------------------------------------------------------------------
MQ Time during which 4 for sold loans
delinquent loan interest 0 otherwise
is passed-through to MBS
holders
----------------------------------------------------------------------------------------------------------------
RHC Net REO holding costs as a 0.1333 UPB-weighted average,
decimal fraction of Freddie Mac ``old book''
Defaulted UPB REO through 1995.
----------------------------------------------------------------------------------------------------------------
MF Time from Default to 18 months UPB-weighted average,
completion of foreclosure Freddie Mac ``old book''
(REO acquisition) REO through 1995.
----------------------------------------------------------------------------------------------------------------
MR Months from REO 13 months UPB-weighted average,
acquisition to REO Freddie Mac ``old book''
disposition REO through 1995.
----------------------------------------------------------------------------------------------------------------
RP REO proceeds as a decimal 0.5888 UPB-weighted average,
fraction of Defaulted UPB Freddie Mac ``old book''
REO through 1995.
----------------------------------------------------------------------------------------------------------------
See also Table 3-39, Explanatory Variable Coefficients for
Multifamily Default.
3.2 Commitments
3.2.1 Commitments Overview
The Enterprises make contractual commitments to purchase or
securitize mortgages. The Stress Test provides for deliveries of
mortgages into the commitments that exist at the start of the Stress
Period. These mortgages are grouped into ``Commitment Loan Groups''
that reflect the characteristics of the mortgages that were
originated in the six months preceding the start of the Stress
Period and securitized by the Enterprise, except that they are
assigned coupon rates consistent with the projected delivery month
in each interest rate scenario. These Commitment Loan Groups are
added to the Enterprise's sold portfolio and the Stress Test
projects their performance during the Stress Period. In the down-
rate scenario, the Stress Test provides that 100 percent of the
mortgages specified in the commitments are delivered within the
first three months. In the up-rate scenario, 75 percent are
delivered within the first six months.
3.2.2 Commitments Inputs
The Stress Test uses two sources of data to determine the
characteristics of the mortgages delivered under commitments:
Information from the Enterprises on the characteristics of
loans originated and delivered to the Enterprises in the six months
preceding the start of the Stress Period, broken out into four
categories, scaled by the dollar value of commitments outstanding at
the start of the Stress Period;
Interest Rate series generated by the Interest Rates
component of the Stress Test.
3.2.2.1 Loan Data
[a] The Enterprises report Commitment Loan Group categories
based on the following product type characteristics of securitized
single family loans originated and delivered during the six months
prior to the start of the Stress Test:
30-year fixed-rate
15-year fixed-rate
One-year CMT ARM
Seven-year balloon
[b] For each Commitment Loan Group category, the Enterprises
report the same information as in section 3.6 for Whole Loan groups
with the following exceptions:
Amortization term and remaining term are set to those
appropriate for newly originated loans
Unamortized balances are set to zero
The House Price Growth Factor is set to one
Age is set to zero
Any credit enhancement coverage other than mortgage
insurance is not reported.
[c] For each Commitment Loan Group category, the Enterprises
report the Starting UPB defined as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.000
3.2.2.2 Interest Rate Data
The Stress Test uses the following Interest Rate series,
generated from section 3.3, Interest Rates, of this Appendix, for
the first 12 months of the Stress Period:
One-year Constant Maturity Treasury yield (CMT)
Conventional mortgage rate (30-year fixed rate)
15-year fixed-rate mortgage rate
Seven-year balloon mortgage rate.
3.2.3 Commitments Procedures
[a] Determine Commitment Loan Groups from the Commitment Loan
Group categories as follows:
1. Divide each category into one subcategory for each delivery
month. Three subcategories are created in the down-rate scenario and
six in the up-rate scenario.
[[Page 47829]]
2. Calculate the total starting UPB for each subcategory as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.001
Where: MDP is taken from Table 3-25.
Table 3-25--Monthly Deliveries as a Percentage of Commitments
Outstanding (MDP)
------------------------------------------------------------------------
Up-Rate Down-Rate
Delivery Month (DM) Scenario Scenario
MDP MDP
------------------------------------------------------------------------
1 18.75% 62.50%
------------------------------------------------------------------------
2 18.75% 25.00%
------------------------------------------------------------------------
3 12.50% 12.50%
------------------------------------------------------------------------
4 12.50% 0.00%
------------------------------------------------------------------------
5 6.25% 0.00%
------------------------------------------------------------------------
6 6.25% 0.00%
------------------------------------------------------------------------
Total 75% 100%
------------------------------------------------------------------------
3. Set the Initial Mortgage Interest Rate for each subcategory using
the interest rate series consistent with the commitment product
type. For fixed rate loans, this rate = INDEXDM. For ARM
loans, the Initial Mortgage Interest Rate and the Mortgage Interest
Rate at Origination are equal and set to INDEXDM-LB-1
+MARGIN, where LB (Lookback Period) and MARGIN for ARM commitment
loan groups come from the RBC Report. Calculate the mortgage payment
amount consistent with the Initial rate and amortizing term.
[b] Cash flows for the commitment loan groups, broken down by
subcategory corresponding to assumed month of delivery to the
Enterprises, are to be generated using the same procedures as
contained in section 3.6, Whole Loan Cash Flows, of this Appendix,
except as follows:
1. For purposes of generating cash flows, treat each commitment loan
subcategory as if the loans were newly originated and delivered just
prior to the start of the Stress Test (that is, treat them as if
mortgage age at time zero, A0, were zero).
2. Wherever section 3.6, Whole Loan Cash Flows, of this Appendix,
refers to interest rate or discount rate adjustments, add Delivery
Month (DM) to the Interest Rate or discount rate monthly counter,
where constant DM . [1,2,3,4,5,6] refers to the number of months
into the Stress Test that the commitment subcategory is assumed to
be delivered to the Enterprise. For example,
a. Section 3.6.3.3.3[a]1.b.3) of this Appendix, if m is a rate
reset month, then:
[GRAPHIC] [TIFF OMITTED] TR13SE01.002
b. Section 3.6.3.4.3.1[a]3.a., of this Appendix,
[GRAPHIC] [TIFF OMITTED] TR13SE01.003
c. Section 3.6.3.4.3.1[a]4., of this Appendix,
[GRAPHIC] [TIFF OMITTED] TR13SE01.004
d. Section 3.6.3.4.3.1[a]5., of this Appendix,
[GRAPHIC] [TIFF OMITTED] TR13SE01.005
e. Section 3.6.3.6.5.1, of this Appendix. Throughout this
section replace DRm with DRm+DM wherever it
appears.
f. Section 3.6.3.7.3[a]9.b., of this Appendix. The formula for
float income received should replace FERm with
FERm+DM
3. For purpose of computing LTVq as defined in section
3.6.3.4.3.1[a]2.a., of this Appendix, adjust the quarterly index for
the vector of house price growth rates by adding DQ=2 if the loans
are delivered in the Stress Test month 6, DQ = 1 if the loans are
delivered in Stress Test months 3, 4 or 5, and 0 otherwise. That is,
in the LTVq formula:
[GRAPHIC] [TIFF OMITTED] TR13SE01.006
Where:
[GRAPHIC] [TIFF OMITTED] TR13SE01.007
4. The note at the end of section 3.6.3.4.3.2[a]5., of this
Appendix, should be adjusted to read: for m > 120-DM, use
MPR120-DM and MDR120-DM.
5. Adjust the final outputs for each commitment subcategory by
adding DM to each monthly counter, m. That is, the outputs in Table
3-52 and 3-55 should be revised to replace each value's monthly
counter of m with the new counter of m + DM, which will modify the
description of each to read ``in month m = 1 + DM, ... RM+DM''.
(Note that for one variable, PUPBm, the revised counter
will range from DM to RM + DM). The revised monthly counters will
now correspond to the months of the Stress Test. For values of m
under the revised description which are less than or equal to DM,
each variable (except Performing UPB) in these two tables should
equal zero. For Performing UPB in month DM, the variable will equal
the Original UPB for month DM and will equal zero for months less
than DM.
3.2.4 Commitments Outputs
[a] The outputs of the Commitment component of the Stress Test
include Commitment Loan Groups specified in the same way as loan
groups in the RBC Report (See section 3.6, Whole Loan Cash Flows, of
this Appendix) with two exceptions: mortgage insurance is the only
available credit enhancement coverage; and delivery month is added
to indicate the month in which these loan groups are added to the
sold portfolio. The data for these loan groups allow the Stress Test
to project the Default, Prepayment and loss rates and cash flows for
loans purchased under commitments for the ten-year Stress Period.
[b] The Commitment outputs also include cash flows analagous to
those specified for Whole Loans in section 3.6.4, Final Whole Loan
Cash Flow Outputs, of this Appendix, which are produced for each
Commitment Loan Group.
3.3 Interest Rates
3.3.1 Interest Rates Overview
[a] The Interest Rates component of the Stress Test projects
Constant Maturity Treasury yields as well as other interest rates
and indexes (collectively, ``Interest Rates'') that are needed to
project mortgage performance and calculate cash flows for mortgages
and other financial instruments for each of the 120 months in the
Stress Period.
[b] The process for determining interest rates is as follows:
first, identify values for the necessary Interest Rates at time
zero; second, project the ten-year CMT for each month of the Stress
Period as specified in the 1992 Act; third, project the 1-month
Treasury yield, the 3-month, 6-month, 1-, 2-, 3-, 5-, 20- and 30-
year CMTs; and fourth, project non-Treasury Interest Rates,
including the Federal Agency Cost of funds.
[c] In cases where the Stress Test would require interest rates
for maturities other than those specifically projected in Table 3-18
of section 3.1.3, Public Data, of this Appendix, the Interest Rates
component performs a monthly linear interpolation. In cases where
the Stress Test would require an Interest Rate for a maturity
greater than the longest maturity specifically projected for that
index, the Stress Test would use the longest maturity for that
index.
3.3.2 Interest Rates Inputs
The Interest Rates that are input to the Stress Test are set
forth in Table 3-18 of section 3.1.3, Public Data, of this Appendix.
3.3.3 Interest Rates Procedures
[a] Produce Interest Rates for use in the Stress Test using the
following three steps:
1. Project the Ten-Year CMT as specified in the 1992 Act:
a. Down-Rate Scenario. In the Stress Test, the ten-year CMT
changes from its starting level to its new level in equal increments
over the first twelve months of the Stress Period, and remains
constant at the new level for the remaining 108 months of the Stress
Period. The new level of the ten-year CMT in the last 108 months of
the down-rate scenario equals the lesser of:
1) The average of the ten-year CMT for the nine months prior to
the start of the Stress Test, minus 600 basis points; or
2) The average yield of the ten-year CMT for the 36 months prior
to the start of the Stress Test, multiplied by 60 percent;
but in no case less than 50 percent of the average for the nine
months preceding the start of the Stress Period.
b. Up-Rate Scenario. In the Stress Test, the ten-year CMT
changes from its starting level to its new level in equal increments
[[Page 47830]]
over the first twelve months of the Stress Period, and remains at
the new level for the remaining 108 months of the Stress Period. The
new level of the ten-year CMT in the last 108 months of the up-rate
scenario is the greater of:
1) The average of the ten-year CMT for the nine months prior to
the start of the Stress Test, plus 600 basis points; or
2) The average of the ten-year CMT for the 36 months prior to
the start of the Stress Test, multiplied by 160 percent;
but in no case greater than 175 percent of the average of the ten-
year CMT for the nine months preceding the start of the Stress
Period.
2. Project the 1-month Treasury and other CMT yields:
a. Down-Rate Scenario. For the down-rate scenario, the new value
of each of the other Treasury and CMT yields for the last 108 months
of the Stress Test is calculated by multiplying the ten-year CMT by
the appropriate ratio from Table 3-26. For the first 12 months of
the Stress Period, the other rates are computed in the same way as
the ten-year CMT, i.e. from their time zero levels. Each of the
other CMTs changes in equal steps in each of the first twelve months
of the Stress Period until it reaches the new level for the
remaining 108 months of the Stress Test.
Table 3-26--CMT Ratios to the Ten-Year CMT \1\
------------------------------------------------------------------------
------------------------------------------------------------------------
1 MO / 10 YR 0.68271
------------------------------------------------------------------------
3 MO / 10 YR 0.73700
------------------------------------------------------------------------
6 MO / 10 YR 0.76697
------------------------------------------------------------------------
1 YR / 10 YR 0.79995
------------------------------------------------------------------------
2 YR / 10 YR 0.86591
------------------------------------------------------------------------
3 YR / 10 YR 0.89856
------------------------------------------------------------------------
5 YR / 10 YR 0.94646
------------------------------------------------------------------------
20 YR / 10 YR 1.06246
------------------------------------------------------------------------
30 YR / 10 YR 1.03432
------------------------------------------------------------------------
\1\ Source: calculated over the period from May, 1986, through April,
1995.
b. Up-Rate Scenario. In the up-rate scenario, all other Treasury
and CMT yields are equal to the ten-year CMT in the last 108 months
of the Stress Test. Each of the other yields changes in equal
increments over the first twelve months of the Stress Test until it
equals the ten-year CMT.
3. Project Non-Treasury Interest Rates:
a. Non-Treasury Rates. For each of the non-Treasury interest
rates with the exception of mortgage rates, rates during the Stress
Test are computed as a proportional spread to the nearest maturity
Treasury yield as given in Table 3-27. The proportional spread is
the average over the two years prior to the start of the Stress
Test, of the difference between the non-Treasury rate and the
comparable maturity Treasury yield divided by that Treasury yield.
For example, the three month LIBOR proportional spread would be
calculated as the two year average of the ratio:
[GRAPHIC] [TIFF OMITTED] TR13SE01.008
During the Stress Test, the 3-month LIBOR rate is projected by
multiplying the 3-month Treasury yield by 1 plus this average
proportional spread.
b. Mortgage Rates. Mortgage interest rates are projected as
described in this section for other non-Treasury interest rates,
except that an average of the additive, not proportional, spread to
the appropriate Treasury interest rate is used. For example, the 30-
year Conventional Mortgage Rate spread is projected as the average,
over the two years preceding the start of the Stress Test, of:
(Conventional Mortgage Rate minus the ten-year CMT). This spread is
then added to the ten-year CMT for the 120 months of the Stress Test
to obtain the projected Conventional Mortgage Rate.
Table 3-27--Non-Treasury Interest Rates
------------------------------------------------------------------------
Mortgage Rates Spread Based on
------------------------------------------------------------------------
15-year Fixed-rate Mortgage Rate 10-year CMT
------------------------------------------------------------------------
30-year Conventional Mortgage Rate 10-year CMT
------------------------------------------------------------------------
7-year Balloon Mortgage Rate (computed from Conventional
Mortgage Rate)
------------------------------------------------------------------------
Other Non-Treasury Interest Rates
------------------------------------------------------------------------
Overnight Fed Funds 1-month Treasury Yield
------------------------------------------------------------------------
7-day Fed Funds 1-month Treasury Yield
------------------------------------------------------------------------
1-month LIBOR 1-month Treasury Yield
------------------------------------------------------------------------
1-month Federal Agency Cost of Funds 1-month Treasury Yield
------------------------------------------------------------------------
3-month LIBOR 3-month CMT
------------------------------------------------------------------------
3-month Federal Agency Cost of Funds 3-month CMT
------------------------------------------------------------------------
PRIME 3-month CMT
------------------------------------------------------------------------
6-month LIBOR 6-month CMT
------------------------------------------------------------------------
6-month Federal Agency Cost of Funds 6-month CMT
------------------------------------------------------------------------
6-month Fed Funds 6-month CMT
------------------------------------------------------------------------
FHLB 11th District Cost of Funds 1-year CMT
------------------------------------------------------------------------
12-month LIBOR 1-year CMT
------------------------------------------------------------------------
1-year Federal Agency Cost of Funds 1-year CMT
------------------------------------------------------------------------
2-year Federal Agency Cost of Funds 2-year CMT
------------------------------------------------------------------------
3-year Federal Agency Cost of Funds 3-year CMT
------------------------------------------------------------------------
5-year Federal Agency Cost of Funds 5-year CMT
------------------------------------------------------------------------
10-year Federal Agency Cost of Funds 10-year CMT
------------------------------------------------------------------------
[[Page 47831]]
30-year Federal Agency Cost of Funds 30-year CMT
------------------------------------------------------------------------
c. Enterprise Borrowing Rates. In the Stress Test, the Federal
Agency Cost of Funds Index is also called the Enterprise Cost of
Funds during the Stress Period.
3.3.4 Interest Rates Outputs
Interest Rate outputs are monthly values for: the projected ten
points on the Treasury yield curve (1-month, 3-month, 6-month, 1-
year, 2-year, 3-year, 5-year, 10-year, 20-year and 30-year); the 21
non-Treasury rates contained in Table 3-27; and the nine points on
the Enterprise Cost of Funds curve.
3.4 Property Valuation
3.4.1 Property Valuation Overview
[a] The Property Valuation component applies inflation
adjustments to the single family house price growth rates and
multifamily rent growth rates that are used to determine single
family property values and multifamily current debt-service coverage
ratios during the up-rate scenario, as required by the 1992 Act.
[b] Single family house price growth rates during the 120 months
of the Stress Test are calculated from the HPI series for the West
South Central Census Division for the years 1984-1993, as derived
from OFHEO's Third Quarter, 1996 HPI Report. The West South Central
Census Division includes Texas and all of the Benchmark states
except Mississippi. This series is applied to single family loans
nationwide during the Stress Test because the 1992 Act applies a
regional loss experience (the BLE) to the entire nation. In
contrast, house prices are brought forward to the start of the
Stress Test based on local Census Division HPI values available at
the start of the Stress Test.
[c] Multifamily rent growth rates during the 120 months of the
Stress Test are computed using a population-weighted average of the
monthly growth of the Rent of Primary Residence component of the
Consumer Price Index-Urban, which is generated by the U.S.
Department of Labor Bureau of Labor Statistics. The metropolitan
areas used for this computation are the Dallas/Ft. Worth CMSA, the
Houston/Galveston/Brazoria CMSA, and the New Orleans MSA.
[d] Multifamily rental vacancy rates during the 120 months of
the Stress Test are computed using a population-weighted average of
annual rental vacancy rates from the U.S. Department of Commerce,
Bureau of the Census' Housing Vacancy Survey. The metropolitan areas
used for this computation are the Dallas, Houston and Fort Worth
PMSAs and the San Antonio, New Orleans and Oklahoma City MSAs.
[e] Inflation adjustment. In the up-rate scenario, if the ten-
year CMT rises more than 50 percent above the average yield during
the nine months preceding the Stress Period, rent and house price
growth rates are adjusted to account for inflation as required by
the 1992 Act. The single family House Price Growth Rates and the
multifamily Rent Growth Rates are increased by the amount by which
the ten-year CMT exceeds 50 percent of its annualized monthly yield
averaged over the nine months preceding the Stress Test. The
inflation adjustment is applied only in the last 60 months of the
Stress Period.
3.4.2 Property Valuation Inputs
The inputs required for the Property Valuation component are set
forth in Table 3-28.
Table 3-28--Property Valuation Inputs
----------------------------------------------------------------------------------------------------------------
Variable Description Source
----------------------------------------------------------------------------------------------------------------
CMT10m 10-year CMT yield for months m = 1...20 of section 3.3, Interest Rates
the Stress Test
----------------------------------------------------------------------------------------------------------------
ACMT0 Unweighted nine-month average of the ten-year section 3.3, Interest Rates
CMT yield for the nine months immediately
preceding the Stress Test. (Monthly rates
are unweighted monthly averages of daily
rates, bond equivalent yield)
----------------------------------------------------------------------------------------------------------------
HHPGRq HSP Quarterly single family historical house Table 3-19 of section
price growth rates computed from the HPI 3.1.3, Public Data.
series for the Benchmark region and time
period, unadjusted for inflation. The
specific series is the West South Central
Census Division for the years 1984-1993, as
reported in OFHEO's Third Quarter, 1996 HPI
Report.
----------------------------------------------------------------------------------------------------------------
RGm HSP Multifamily Rent Growth Rates for months m = Table 3-20 of section
1...120 of the Benchmark region and time 3.1.3, Public Data.
period, unadjusted for inflation
----------------------------------------------------------------------------------------------------------------
RVRm HSP Multifamily Rental Vacancy Rates for months m Table 3-20 of section
= 1...120 of the Benchmark region and time 3.1.3, Public Data.
period
----------------------------------------------------------------------------------------------------------------
3.4.3 Property Valuation Procedures for Inflation Adjustment
[a] Calculate inflation-adjusted House Price Growth Rates and
Rent Growth Rates using the following six steps:
1. Calculate the Inflation-Adjustment (IA) for the up-rate stress
test, as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.009
Where:
CMT10\MAX\ is the value of the ten-year CMT during the last 108
months of the up-rate Stress Test.
2. The Inflation Adjustment (IA) is compounded annually over 9 years
and 2 months (110 months) to obtain the Cumulative Inflation
Adjustment (CIA) according to the following equation:
[GRAPHIC] [TIFF OMITTED] TR13SE01.010
3. For single family house prices, convert the CIA to continuously
compounded quarterly factors, the Quarterly House Price Growth
Adjustments (QHGAq), which take on positive values only
in the last twenty quarters of the Stress Test, using:
[GRAPHIC] [TIFF OMITTED] TR13SE01.011
4. For Multifamily rent growth, the CIA is converted to discrete
monthly factors or Monthly Rent Growth Adjustments
(MRGAm), and is applied only in the last 60 months of the
Stress Test in the up-rate scenario, as follows:
[[Page 47832]]
[GRAPHIC] [TIFF OMITTED] TR13SE01.012
5. Calculate the inflation-adjusted House Price Growth Rates
(HPGRq), used in updating single family house prices
during the Stress Test:
[GRAPHIC] [TIFF OMITTED] TR13SE01.013
6. Calculate inflation-adjusted Rent Growth Rates (RGRm),
used in updating Multifamily debt-service coverage ratios during the
Stress Test:
[GRAPHIC] [TIFF OMITTED] TR13SE01.014
3.4.4 Property Valuation Outputs
[a] The outputs of the Property Valuation component of the
Stress Test are set forth in Table 3-29.
Table 3-29--Property Valuation Outputs
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
HPGRq House price growth rates for quarters
1...40 of the Stress Test, adjusted
for inflation, if applicable.
------------------------------------------------------------------------
RGRm Multifamily Rent Growth Rates for
months m = 1...120 of the Stress Test,
adjusted for inflation, if applicable.
------------------------------------------------------------------------
RVRm Multifamily Rental Vacancy Rates for
months m = 1...120 of the Stress Test.
------------------------------------------------------------------------
[b] Inflation-adjusted House Price Growth Rates
(HPGRq) are inputs to the Single Family Default and
Prepayment component of the Stress Test (see section 3.6.3.4, of
this Appendix). Inflation-adjusted Rent Growth Rates
(RGRm) and Rental Vacancy Rates (RVRm) are
inputs to the Multifamily Default and Prepayment component (see
section 3.6.3.5, of this Appendix).
3.5 Counterparty Defaults
3.5.1 Counterparty Defaults Overview
The Counterparty Defaults component of the Stress Test accounts
for the risk of default by credit enhancement and derivative
contract counterparties, corporate securities, municipal securities,
and mortgage-related securities. The Stress Test recognizes five
rating categories (``AAA'', ``AA'', ``A'', ``BBB'', and ``Below BBB
and Unrated'') and establishes appropriate credit loss factors that
are applied during the Stress Period. Securities rated below BBB are
treated as unrated securities, unless OFHEO determines to specify a
different treatment upon a showing by an Enterprise that a different
treatment is warranted.
3.5.2 Counterparty Defaults Input
For counterparties and securities, information on counterparty
type and the lowest public rating of the counterparty is required.
The Stress Test uses credit ratings issued by Nationally Recognized
Statistical Rating Organizations (``NRSROs'') to assign rating
categories to counterparties and securities. If a counterparty or
security has different ratings from different rating agencies, i.e.,
a ``split rating,'' or has a long-term rating and a short-term
rating, then the lower rating is used.
3.5.3 Counterparty Defaults Procedures
[a] Apply the following three steps to determine maximum
haircuts:
1. Identifying Counterparties. The Stress Test divides all sources
of credit risk other than mortgage default into two categories--(1)
derivative contract counterparties and (2) non-derivative contract
counterparties and instruments. Non-derivative contract
counterparties and instruments include mortgage insurance (MI)
counterparties, seller-servicers, mortgage-related securities such
as mortgage revenue bonds (MRBs) and private label REMICS, and
nonmortgage investments such as corporate and municipal bonds and
asset-backed securities (ABSs).
2. Classify Rating Categories.
a. Stress Test rating categories are defined as set forth in
Table 3-30. Organizations frequently apply modifiers (numerical,
plus, minus) to the generic rating classifications. In order to
determine the correct mapping, ignore these modifiers except as
noted in Table 3-30.
Table 3-30--Rating Agencies Mappings to OFHEO Ratings Categories
----------------------------------------------------------------------------------------------------------------
OFHEO Ratings Below BBB and
Category AAA AA A BBB Unrated
----------------------------------------------------------------------------------------------------------------
Standard & Poor's AAA AA A BBB Below BBB and
Long-Term Unrated
----------------------------------------------------------------------------------------------------------------
Fitch Long-Term AAA AA A BBB Below BBB and
Unrated
----------------------------------------------------------------------------------------------------------------
Moody's Long-Term Aaa Aa A Baa Below Baa and
Unrated
----------------------------------------------------------------------------------------------------------------
Standard & Poor's A-1+ A-1 A-2 A-3 Below A-3 and
Short-Term Unrated
----------------------------------------------------------------------------------------------------------------
Fitch Short-Term F-1+ F-1 F-2 F-3 Below F-3 and
Unrated
----------------------------------------------------------------------------------------------------------------
Moody's Short-Term P-1 P-1 P-2 P-3 Below P-3 and
\1\ Unrated
----------------------------------------------------------------------------------------------------------------
Fitch Bank Ratings A B C D E
----------------------------------------------------------------------------------------------------------------
\1\ Any short-term rating that appears in more than one OFHEO category column is assigned the lower OFHEO rating
category.
b. The Stress Test also includes a ratings classification called
cash. This includes cash equivalents as defined in FAS 95,
Government securities, and securities of the reporting Enterprise.
c. Unrated, unsubordinated obligations issued by Government
Sponsored Enterprises other than the reporting Enterprise are
treated as AAA. Unrated seller-servicers are treated as BBB.
3. Determine Maximum Haircuts. The Stress Test specifies the Maximum
Haircut (i.e., the maximum reduction applied to cash flows during
the Stress Test to reflect the default of counterparties or
securities) by rating category and counterparty type as shown in
Table 3-31. Haircuts for the Below BBB and Unrated category are
applied fully starting in the first month of the Stress Test. For
nonmortgage instruments, Haircuts for the Below BBB and Unrated
category are applied to 100 percent of the principal balance and
interest due on the date of the first cash flow. For other
categories, Haircuts are phased in linearly over the first 60 months
of the Stress Test. The Maximum Haircut is applied in months 60
through 120 of the Stress Period.
[[Page 47833]]
Table 3-31--Stress Test Maximum Haircut by Ratings Classification
------------------------------------------------------------------------
Non-Derivative
Derivative Contract Number of
Ratings Classification Contract Counterparties Phase-in
Counterparties or Instruments Months
------------------------------------------------------------------------
Cash 0% 0% N/A
------------------------------------------------------------------------
AAA 2% 5% 60
------------------------------------------------------------------------
AA 4% 15% 60
------------------------------------------------------------------------
A 8% 20% 60
------------------------------------------------------------------------
BBB 16% 40% 60
------------------------------------------------------------------------
Below BBB and Unrated 100% 100% 1
------------------------------------------------------------------------
3.5.4 Counterparty Defaults Outputs
The Maximum Haircut for a given Counterparty Type and Rating
Classification is used in section 3.6, Whole Loan Cash Flows,
section 3.7, Mortgage-Related Securities Cash Flows, and section
3.8, Nonmortgage Instrument Cash Flows, of this Appendix.
3.6 Whole Loan Cash Flows
3.6.1 Whole Loan Cash Flows Overview
[a] Loan Aggregation. In the Stress Test calculations (except as
described in section 3.6.3.6.4, Mortgage Credit Enhancement, of this
Appendix), individual loans having similar characteristics are
aggregated into Loan Groups as described in section 3.1.2.1, Whole
Loan Inputs, of this Appendix (RBC Report). All individual loans
within a Loan Group are considered to be identical for computational
purposes. In the discussions in this section, quantities described
as ``loan level'' will actually be computed at the Loan Group level.
[b] Loan Participations. In some cases, an Enterprise may hold
only a pari passu fractional ownership interest in a loan. This
interest is referred to as a participation, and is specified by the
ownership percentage held by the Enterprise (the participation
percentage). In such cases, the Unpaid Principal Balance (UPB) and
Mortgage Payment reported in the RBC Report will be only the
Enterprise's participation percentage of the loan's actual UPB and
Mortgage Payment. The actual UPB is not explicitly used in the
calculations described in this section 3.6 but it is used in the
creation of the RBC Report.
[c] Retained Loans vs. Sold Loans. The Stress Test models cash
flows from single family and multifamily mortgage loans that are
held in portfolio (Retained Loans) and loans that are pooled into
Mortgage-Backed Securities (MBSs) that are sold to investors and
guaranteed by the Enterprises (Sold Loans). Together, Retained Loans
and Sold Loans are referred to as ``Whole Loans.'' The treatment of
cash flows for loans not guaranteed by the Enterprises, e.g., loans
backing GNMA Certificates and private label MBSs and REMICs, is
discussed in section 3.7, Mortgage-Related Securities Cash Flows, of
this Appendix.
[d] Repurchased MBSs. From time to time an Enterprise may
repurchase all or part of one of its own previously issued single-
class MBSs for its own securities portfolio. At an Enterprise's
option, these ``Repurchased MBSs'' may be reported with the
underlying Whole Loans for computation in this section 3.6 rather
than in section 3.7, Mortgage-Related Securities Cash Flows, of this
Appendix. In such cases, the Enterprise will report the underlying
Whole Loans as sold loans, along with the appropriate Fraction
Repurchased and any security unamortized balances associated with
the purchase of the MBS (not with the original sale of the
underlying loans, which unamortized balances are reported
separately).
[e] Sources of Enterprise Whole Loan Cash Flows. For Retained
Loans, the Enterprises receive all principal and interest payments
on the loans, except for a portion of the interest payment retained
by the servicer as compensation (the Servicing Fee). For Sold Loans,
the Enterprises receive Guarantee Fees and Float Income. Float
Income is the earnings on the investment of loan principal and
interest payments (net of the Servicing Fee and Guarantee Fee) from
the time these payments are received from the servicer until they
are remitted to security holders. The length of this period depends
on the security payment cycle (the remittance cycle). For both
retained and sold loans, the Enterprises retain 100 percent of their
credit losses and experience amortization of discounts as income and
amortization of premiums as expense. For Repurchased MBSs, the
Enterprise receives the Fraction Repurchased of the cash flows it
remits to investors, and retains 100 percent of the Credit Losses,
the Guarantee Fee and the Float Income. See section 3.6.3.7, Stress
Test Whole Loan Cash Flows and section 3.6.3.8, Whole Loan
Accounting Flows, of this Appendix.
[f] Required Inputs. The calculation of Whole Loan cash flows
requires mortgage Amortization Schedules, mortgage Prepayment,
Default and Loss Severity rates, and Credit Enhancement information.
The four mortgage performance components of the Stress Test are
single family Default and Prepayment, single family Loss Severity,
multifamily Default and Prepayment, and multifamily Loss Severity.
Mortgage Amortization Schedules are computed from input data in the
RBC Report. (For ARMs, selected interest rate indexes from section
3.3, Interest Rates, of this Appendix, are also used.) Prepayment
and Default Rates are computed by combining explanatory variables
and weighting coefficients according to a set of logistic equations.
The explanatory variables are computed from the mortgage
Amortization Schedule and external economic variables such as
Interest Rates (section 3.3, Interest Rates, of this Appendix),
historical house-price indexes (HPIs) or rental-price indexes
(RPIs), and Stress Period HPI growth rate, RPI and Vacancy Rate
(RVR) series from section 3.4, Property Valuation, of this Appendix.
The weighting coefficients determine the relative importance of the
different explanatory variables, and are estimated from a
statistical analysis of data from the Benchmark Loss region and time
period as described in section 1, Identification of the Benchmark
Loss Experience, of this Appendix. Mortgage Amortization information
is also combined with HPI, RPI and VR series to determine Gross Loss
Severity rates, which are offset by Credit Enhancements. Finally,
the Amortization Schedules, Default and Prepayment rates and Net
Loss Severity rates are combined to produce Stress Test Whole Loan
Cash Flows to the Enterprises for each Loan Group, as well as
amortization of any discounts, premiums and fees.
[g] Specification of Mortgage Prepayment. Mortgages are assumed
to prepay in full. The model makes no specific provision for partial
Prepayments of principal (curtailments).
[h] Specification of Mortgage Default and Loss. Mortgage
Defaults are modeled as follows: Defaulting loans enter foreclosure
after a number of missed payments (MQ, Months in Delinquency), and
are foreclosed upon several months later. Months in Foreclosure (MF)
is the total number of missed payments through foreclosure. Upon
completion of foreclosure, the loan as such ceases to exist and the
property becomes Real Estate Owned by the lender (REO). Foreclosure
expenses are paid and MI proceeds received when foreclosure is
completed. After several more months (MR, Months in REO), the
property is sold, REO expenses are paid, and sales proceeds and
other credit enhancements are received. These timing differences are
not modeled explicitly in the cash flows, but their economic effect
is taken into account by calculating the present value of the
Default-related cash flows back to the initial month of Default.
[i] Combining Cash Flows from Scheduled Payments, Prepayments
and Defaults. Aggregate Whole Loan Cash Flows, adjusted for the
effects of mortgage performance, are based on the following
conceptual equation,
[[Page 47834]]
which is made more explicit in the calculations in the sections
specified in section 3.6.2 of this Appendix:
[GRAPHIC] [TIFF OMITTED] TR13SE01.015
3.6.2 Whole Loan Cash Flows Inputs
Inputs for each stage of the Whole Loan Cash Flows calculation
are found in the following sections:
Section 3.6.3.3.2, Mortgage Amortization Schedule Inputs
Section 3.6.3.4.2, Single Family Default and Prepayment
Inputs
Section 3.6.3.5.2, Multifamily Default and Prepayment
Inputs
Section 3.6.3.6.2.2, Single Family Gross Loss Severity
Inputs
Section 3.6.3.6.3.2, Multifamily Gross Loss Severity Inputs
Section 3.6.3.6.4.2, Mortgage Credit Enhancement Inputs
Section 3.6.3.7.2, Stress Test Whole Loan Cash Flow Inputs
Section 3.6.3.8.2, Whole Loan Accounting Flows Inputs, of
this Appendix
3.6.3 Whole Loan Cash Flows Procedures
3.6.3.1 Timing Conventions
[a] Calculations are monthly. The Stress Test operates monthly,
with all events of a given type assumed to take place on the same
day of the month. For mortgages, unless otherwise specified, all
payments and other mortgage-related cash flows that are due on the
first day of the month are received on the fifteenth. Biweekly loans
are mapped into their closest term-equivalent monthly counterpart.
[b] ``Time Zero'' for Calculations. Time Zero refers to the
beginning of the Stress Test. For example, if the 2Q2000 Stress Test
uses Enterprise Data as of June 30, ``month zero'' represents
conditions as of June 30, the Stress Period begins July 1, and July
2000 is month one of the Stress Test. In this document,
UPB0 is the Unpaid Principal Balance of a loan
immediately prior to (as of) the start of the Stress Test, i.e. as
reported by the Enterprise in the RBC Report. Origination refers to
the beginning of the life of the loan, which will be prior to the
start of the Stress Test for all loans except those delivered later
under Commitments, for which Origination refers to the delivery
month (See section 3.2, Commitments, of this Appendix).
[c] Definition of Mortgage Age. The Mortgage Age at a given time
is the number of scheduled mortgage payment dates that have occurred
prior to that time, whether or not the borrower has actually made
the payments. Prior to the first payment date, the Mortgage Age
would be zero. From the first payment date until (but not including)
the second loan payment date, the Mortgage Age would be one. The
Mortgage Age at Time Zero (A0) is thus the number of
scheduled loan payment dates that have occurred prior to the start
of the Stress Test. The scheduled payment date for all loans is
assumed to be the first day of each month; therefore, the Mortgage
Age will be A1 on the first day of the Stress Test
(except for Commitments that are delivered after the start of the
Stress Test).
[d] Interest Rate Setting Procedure. Mortgage interest is due in
arrears, i.e., on the first day following the month in which it is
accrued. Thus, a payment due on the first day of month m is for
interest accrued during the prior month. For example, for Adjustable
Rate Mortgages (ARMs) the Mortgage Interest Rate (MIRm)
applicable to the July reset is set on the first day of June, and is
generally based on the May or April value of the underlying Index,
as specified in the loan terms. This Lookback Period (LB) is
specified in the Stress Test as a period of one or two months,
respectively. Thus, PMTm will be based on
MIRm, which is based on
INDEXm-1-LB.
[e] Prepayment Interest Shortfall. In some remittance cycles,
the period between an Enterprise's receipt of Prepayments and
transmittal to investors exceeds a full month. In those cases, the
Enterprise must remit an additional month's interest (at the Pass-
Through Rate) to MBS investors. See section 3.6.3.7.3, Stress Test
Whole Loan Cash Flow Procedures, of this Appendix.
[f] Certain Calculations Extend Beyond the End of the Stress
Test. Even though the Stress Test calculates capital only through
the ten year Stress Period, certain calculations (for example, the
level yield amortization of discounts, premiums and fees, as
described in section 3.10, Operations, Taxes, and Accounting, of
this Appendix) require cash flows throughout the life of the
instrument. For such calculations in the Stress Test, the conditions
of month 120 are held constant throughout the remaining life of the
instrument: specifically, Interest Rates (which are already held
constant for months 13 through 120), Prepayment and Default rates
for months m > 120 are taken to be equal to their respective values
in month 120.
3.6.3.2 Payment Allocation Conventions
3.6.3.2.1 Allocation of Mortgage Interest
[a] Components of Mortgage Interest. The interest portion of the
Mortgage Payment is allocated among several components. For all
Whole Loans, a Servicing Fee is retained by the servicer. For Sold
Loans, the Enterprise retains a Guarantee Fee. An additional amount
of interest (Spread) \1\ may be deposited into a Spread Account to
reimburse potential future credit losses on loans covered by this
form of Credit Enhancement, as described further in section
3.6.3.6.4, Mortgage Credit Enhancement, of this Appendix. The
remaining interest amount is either retained by the Enterprise (Net
Yield on Retained Loans) or passed through to MBS investors (Pass-
Through Interest on Sold Loans).
---------------------------------------------------------------------------
\1\ The spread may or may not be embedded in the recorded
Servicing Fee.
---------------------------------------------------------------------------
[b] Effect of Negative Amortization. If the Mortgage Payment is
contractually limited to an amount less than the full amount accrued
(as may be the case with loans that permit Negative Amortization),
then the Servicing Fee, the Guarantee Fee and the spread are paid in
full, and the shortfall is borne entirely by the recipient of the
Net Yield or Pass-Through Interest.
[c] Effect of Variable Rates. For ARMs, the Servicing Fee,
Guarantee Fee and Spread rates are taken to be constant over time,
as they are for Fixed Rate Loans. Thus in the Stress Test the
Mortgage Interest Rate and the Net Yield or Pass-through Rate will
change simultaneously by equal amounts. All other details of the
rate and payment reset mechanisms are modeled in accordance with the
contractual terms using the inputs specified in section 3.6.3.3.2,
Mortgage Amortization Schedule Inputs, of this Appendix.
3.6.3.2.2 Allocation of Mortgage Principal
[a] Scheduled Principal is that amount of the mortgage payment
that amortizes principal. For calculational purposes, when a loan
prepays in full the amount specified in the Amortization Schedule is
counted as Scheduled Principal, and the rest is Prepayment
Principal. For a Balloon Loan, the final Balloon Payment includes
the remaining UPB, all of which is counted as Scheduled Principal.
[b] Mortgages that prepay are assumed to prepay in full. Partial
Prepayments (curtailments) are not modeled.
[c] Any loan that does not prepay or Default remains on its
original Amortization Schedule.
3.6.3.3 Mortgage Amortization Schedule
3.6.3.3.1 Mortgage Amortization Schedule Overview
[a] The Stress Test requires an Amortization Schedule for each
Loan Group. A mortgage is paid down, or amortized over time, to the
extent that the contractual mortgage payment exceeds the amount
required to cover interest due.
[b] Definitions.
1. Fully Amortizing Loans. The Amortization Schedule for a mortgage
with age A0 at the beginning of the Stress Test is
generated using the starting UPB (UPB0), the Remaining
Term to Maturity (RM), the remaining Amortization Term
(AT-A0), the remaining Mortgage
[[Page 47835]]
Payments (PMTm for m = 1...RM) and Mortgage Interest
Rates (MIRm for m = 1...RM). The Amortization Schedule is
generated by repeating the following three steps iteratively until
the UPB is zero:
a. Interest Due =
UPB x Mortgage Interest Rate
b. Principal Amortization = Payment-Interest Due
c. Next period's UPB =
UPB-Principal Amortization
2. Balloon Loans. A Balloon Loan matures prior to its Amortizing
Term, i.e. before the UPB is fully amortized to zero.
Computationally, AT-A0 > RM, usually by at least 180
months. In order that UPBRM = 0, the principal component
of the resulting lump sum final payment (the Balloon Payment, equal
to UPBRM-1) is counted as Scheduled Principal, not as a
Prepayment.
[c] Special Cases. In general the UPB of a mortgage decreases
monotonically over time, i.e. UPBm > UPBm+1,
reaching zero at maturity except for Balloon Loans as described in
[b]2. in this section. However, in practice certain exceptions must
be handled.
1. Interest-Only Loans. Certain loans are interest-only for all or
part of their term. The monthly payment covers only the interest
due, and the UPB stays constant until maturity (in some cases), in
which case a Balloon Payment is due or a changeover date (in other
cases) at which time the payment is recast so that the loan begins
to amortize over its remaining term. If the loan does not amortize
fully over its remaining term, a Balloon Payment will be due at
maturity.
2. Negative Amortization. For some loans, the UPB may increase for a
period of time if the mortgage payment is contractually limited to
an amount that is less than the amount of interest due, and the
remainder is added to the UPB. At some point, however, the payment
must exceed the interest due or else the loan balance will never be
reduced to zero. In the calculation, this is permitted to occur only
for payment-capped ARMs that contractually specify negative
amortization. Certain types of FRMs, notably Graduated Payment
Mortgages (GPMs) and Tiered Payment Mortgages (TPMs), also have
variable payment schedules that result in negative amortization, but
in the Stress Test all such loans are assumed to have passed their
negative amortization periods.
3. Early Amortization.
a. If a borrower has made additional principal payments
(curtailments or partial prepayments) on a FRM prior to the start of
the Stress Test, the contractual mortgage payment will amortize the
loan prior to its final maturity, i.e. UPBm = 0 for some
m RM. This is an acceptable outcome in the Stress Test. Note: for
ARMs, the mortgage payment is recalculated, and thus the
amortization schedule is recast to end exactly at m = RM, on each
rate or payment reset date.
b. When this calculation is performed for a fully amortizing FRM
using weighted average values to represent a Loan Group, the final
scheduled payment may exceed the amount required to reduce the UPB
to zero, or the UPB may reach zero prior to month RM. This is
because the mortgage payment calculation is nonlinear, and as a
result the average mortgage payment is not mathematically guaranteed
to amortize the average UPB using the average MIR. This is an
acceptable outcome in the Stress Test.
4. Late Amortization. According to its contractual terms, the UPB of
a mortgage loan must reach zero at its scheduled maturity. The
borrower receives a disclosure schedule that explicitly sets forth
such an Amortization Schedule. If the characteristics of a mortgage
loan representing a Loan Group in the RBC Report do not result in
UPBRM = 0, it must be for one of three reasons: a data
error, an averaging artifact, or an extension of the Amortization
Schedule related to a delinquency prior to the start of the Stress
Test. In any such case, the Stress Test does not recognize cash
flows beyond the scheduled maturity date and models the performing
portion of UPBRM in month RM as a credit loss.
[d] Biweekly Loans. Biweekly loans are mapped into the FRM
category that most closely approximates their final maturity.
[e] Step-Rate (or ``Two-Step'') Loans. Certain loans have an
initial interest rate for an extended period of time (typically
several years) and then ``step'' to a final fixed rate for the
remaining life of the loan. This final fixed rate may be either a
predetermined number or a margin over an index. Such loans can be
exactly represented as ARMs with the appropriate Initial Mortgage
Interest Rate and Initial Rate Period, Index and Margin (if
applicable). If the final rate is a predetermined rate (e.g., 8
percent per annum) then the ARM's Maximum and Minimum Rate should be
set to that number. The Rate and Payment Reset Periods should be set
equal to the final rate period after the step.
3.6.3.3.2 Mortgage Amortization Schedule Inputs
The inputs needed to calculate the amortization schedule are set
forth in Table 3-32:
Table 3-32--Loan Group Inputs for Mortgage Amortization Calculation
----------------------------------------------------------------------------------------------------------------
Variable* Description Source
----------------------------------------------------------------------------------------------------------------
Rate Type (Fixed or Adjustable) RBC Report
----------------------------------------------------------------------------------------------------------------
Product Type (30/20/15-Year FRM, ARM, RBC Report
Balloon, Government, etc.)
----------------------------------------------------------------------------------------------------------------
UPBORIG Unpaid Principal Balance at Origination RBC Report
(aggregate for Loan Group)
----------------------------------------------------------------------------------------------------------------
UPB0 Unpaid Principal Balance at start of Stress RBC Report
Test (aggregate for Loan Group)
----------------------------------------------------------------------------------------------------------------
MIR0 Mortgage Interest Rate for the Mortgage RBC Report
Payment prior to the start of the Stress
Test, or Initial Mortgage Interest Rate for
new loans (weighted average for Loan Group)
(expressed as a decimal per annum)
----------------------------------------------------------------------------------------------------------------
PMT0 Amount of the Mortgage Payment (Principal and RBC Report
Interest) prior to the start of the Stress
Test, or first payment for new loans
(aggregate for Loan Group)
----------------------------------------------------------------------------------------------------------------
AT Original loan Amortizing Term in months RBC Report
(weighted average for Loan Group)
----------------------------------------------------------------------------------------------------------------
RM Remaining term to Maturity in months (i.e., RBC Report
number of contractual payments due between
the start of the Stress Test and the
contractual maturity date of the loan)
(weighted average for Loan Group)
----------------------------------------------------------------------------------------------------------------
A0 Age immediately prior to the start of the RBC Report
Stress Test, in months (weighted average for
Loan Group)
----------------------------------------------------------------------------------------------------------------
Additional Interest Rate Inputs
----------------------------------------------------------------------------------------------------------------
GFR Guarantee Fee Rate (weighted average for Loan RBC Report
Group) (decimal per annum)
----------------------------------------------------------------------------------------------------------------
SFR Servicing Fee Rate (weighted average for Loan RBC Report
Group) (decimal per annum)
----------------------------------------------------------------------------------------------------------------
Additional Inputs for ARMs (weighted averages for Loan Group, except for Index)
----------------------------------------------------------------------------------------------------------------
[[Page 47836]]
INDEXM Monthly values of the contractual Interest section 3.3, Interest Rates
Rate Index
----------------------------------------------------------------------------------------------------------------
LB Look-Back period, in months RBC Report
----------------------------------------------------------------------------------------------------------------
MARGIN Loan Margin (over index), decimal per annum RBC Report
----------------------------------------------------------------------------------------------------------------
RRP Rate Reset Period, in months RBC Report
----------------------------------------------------------------------------------------------------------------
Rate Reset Limit (up and down), decimal per RBC Report
annum
----------------------------------------------------------------------------------------------------------------
Maximum Rate (life cap), decimal per annum RBC Report
----------------------------------------------------------------------------------------------------------------
Minimum Rate (life floor), decimal per annum RBC Report
----------------------------------------------------------------------------------------------------------------
NAC Negative Amortization Cap, decimal fraction RBC Report
of UPBORIG
----------------------------------------------------------------------------------------------------------------
Unlimited Payment Reset Period, in months RBC Report
----------------------------------------------------------------------------------------------------------------
PRP Payment Reset Period, in months RBC Report
----------------------------------------------------------------------------------------------------------------
Payment Reset Limit, as decimal fraction of RBC Report
prior payment
----------------------------------------------------------------------------------------------------------------
IRP Initial Rate Period, in months RBC Report
----------------------------------------------------------------------------------------------------------------
Additional Inputs for Multifamily Loans
----------------------------------------------------------------------------------------------------------------
Interest-only Flag RBC Report
----------------------------------------------------------------------------------------------------------------
RIOP Remaining Interest-only period, in months RBC Report
(weighted average for loan group)
----------------------------------------------------------------------------------------------------------------
* Variable name is given when used in an equation
3.6.3.3.3 Mortgage Amortization Schedule Procedures
[a] For each Loan Group, calculate a mortgage Amortization
Schedule using the inputs in Table 3-32 and the following ten steps.
Note: Do not round dollar amounts to the nearest penny.)
For months m = 1...RM, calculate quantities for month m based on
values from month m-1 as follows:
1. Calculate current month's Mortgage Interest Rate
(MIRm).
a. For FRMs: MIRm = MIR0 for all m = 1 to
RM
b. For ARMs, use the following procedure:
1) If RRP = PRP then month m is a rate reset month if:
[GRAPHIC] [TIFF OMITTED] TR13SE01.016
2) If RRP PRP then month m is a rate reset month if
either:
a) A0 + m - (IRP + 1) = 0, or
b) [A0 + m - 1] mod RRP = 0 and A0 + m - 1
IRP
3) If m is a rate reset month, then:
[GRAPHIC] [TIFF OMITTED] TR13SE01.017
but not greater than MIRm-1 + Rate Reset Limit
nor less than MIRm-1 - Rate Reset Limit
and in no case greater than Maximum Rate
and in no case less than Minimum Rate
4) If month m is not a rate reset month, then MIRm =
MIRm-1.
c. In all cases, MIRm = MIR120 for m >
120, and MIR m = 0 for m > RM.
2. Calculate current month's Payment (PMTm).
a. For FRMs:
1) For Interest-Only Loans, if m = RIOP + 1 then month m is a
reset month; recompute PMTm as described for ARMs in step
b.4)b), of this section without applying any payment limit.
2) PMTm = PMT0 for all m = 1 to RM
b. For ARMs, use the following procedure:
1) For Interest Only Loans, if m = RIOP + 1 then month m is a
payment reset month.
2) If PRP = RRP, then month m is a payment reset month if m is
also a rate reset month.
3) If PRP RRP then month m is a payment reset month if:
[GRAPHIC] [TIFF OMITTED] TR13SE01.018
4) If month m is a payment reset month, then:
a) For loans in an Interest-only Period,
[GRAPHIC] [TIFF OMITTED] TR13SE01.019
b) Otherwise, PMTm = the amount that will fully
amortize the Loan over its remaining Amortizing Term (i.e.
AT-Ao-m+1 months) with a fixed Mortgage Interest Rate
equal to MIRm as determined in Step 1 of this section
but not greater than PMTm-1 x (1 + Payment Reset
Limit Up)
nor less than PMTm-1 x (1-Payment Reset Limit
Down)
unless month m is the month following the end of an Unlimited
Payment Reset Period, in which case PMTm is not subject
to any reset limitations.
5) If month m is not a payment reset month, then PMTm
= PMTm-1
6) If, in any month,
[GRAPHIC] [TIFF OMITTED] TR13SE01.020
then recalculate PMTm without applying any Payment
Reset Limit.
c. For Balloon Loans, or for loans that have RIOP = RM, if m =
RM then:
[GRAPHIC] [TIFF OMITTED] TR13SE01.021
d. In all cases, PMTm should amortize the loan within
the Remaining Maturity:
[GRAPHIC] [TIFF OMITTED] TR13SE01.022
3. Determine Net Yield Rate (NYRm) and, for sold loans,
Pass-Through Rate (PTRm) applicable to the mth
payment:
[GRAPHIC] [TIFF OMITTED] TR13SE01.023
4. Calculate Scheduled Interest Accrued (during month m-1) on
account of the mth payment (SIAm)
[GRAPHIC] [TIFF OMITTED] TR13SE01.024
5. Calculate the Scheduled Interest component of the mth
payment (SIm)
[GRAPHIC] [TIFF OMITTED] TR13SE01.025
6. Calculate Scheduled Principal for the mth payment
(SPm):
[GRAPHIC] [TIFF OMITTED] TR13SE01.026
Note:
Scheduled Principal should not be greater than the remaining
UPB. SPM can be
[[Page 47837]]
negative if the Scheduled Payment is less than Scheduled Interest
Accrued.
7. Calculate Loan Unpaid Principal Balance after taking into account
the mth monthly payment (UPBm):
[GRAPHIC] [TIFF OMITTED] TR13SE01.027
8. In the month when UPBm is reduced to zero, reset
[GRAPHIC] [TIFF OMITTED] TR13SE01.028
9. Repeat all steps for m = 1...RM or until UPBm = 0.
Note:
If UPBRM is greater than zero, the performing portion
is included in Credit Losses (section 3.6.3.7.3, Stress Test Whole
Loan Cash Flow Procedures, of this Appendix).
10. Determine Net Yield Rate (NYRo) and, for sold
loans, Pass-Through Rate (PTRo) for month 0:
[GRAPHIC] [TIFF OMITTED] TR13SE01.029
3.6.3.3.4 Mortgage Amortization Schedule Outputs
The Mortgage Amortization Schedule Outputs set forth in Table 3-
33 are used in section 3.6.3.4, Single Family Default and Prepayment
Rates, section 3.6.3.5, Multifamily Default and Prepayment Rates,
section 3.6.3.6, Calculation of Single Family and Multifamily
Mortgage Losses, section 3.6.3.7, Stress Test Whole Loan Cash Flows,
and section 3.6.3.8, Whole Loan Accounting Flows, of this Appendix.
Table 3-33--Mortgage Amortization Schedule Outputs
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
UPBm Unpaid Principal Balance for months
m=1...RM
------------------------------------------------------------------------
MIRm Mortgage Interest Rate for months
m=1...RM
------------------------------------------------------------------------
NYRm Net Yield Rate for months m=1...RM
------------------------------------------------------------------------
PTRm Passthrough Rate for months m=1...RM
------------------------------------------------------------------------
SPm Scheduled Principal (Amortization) for
months m=1...RM
------------------------------------------------------------------------
SIm Scheduled Interest for months m=1...RM
------------------------------------------------------------------------
PMTm Scheduled Mortgage Payment for months
m=1...RM
------------------------------------------------------------------------
3.6.3.4 Single Family Default and Prepayment Rates
3.6.3.4.1 Single Family Default and Prepayment Overview
[a] The Stress Test projects conditional Default and Prepayment
rates for each single family Loan Group for each month of the Stress
Period. The conditional rate is the percentage (by principal
balance) of the remaining loans in a Loan Group that defaults or
prepays during a given period of time. Computing Default and
Prepayment rates for a Loan Group requires information on the Loan
Group characteristics at the beginning of the Stress Test,
historical and projected interest rates from section 3.3, Interest
Rates, and house price growth rates and volatility measures from
section 3.4, Property Valuation, of this Appendix.
[b] Explanatory Variables. Several explanatory variables are
used in the equations to determine Default and Prepayment rates for
single family loans: Mortgage Age, Original Loan-to-Value (LTV)
ratio, Probability of Negative Equity, Burnout, the percentage of
Investor-owned Loans, Relative Interest Rate Spread, Payment Shock
(for ARMs only), Initial Rate Effect (for ARMs only), Yield Curve
Slope, Relative Loan Size, and Mortgage Product Type. Regression
coefficients (weights) are associated with each variable. All of
this information is used to compute conditional quarterly Default
and Prepayment rates throughout the Stress Test. The quarterly rates
are then converted to monthly conditional Default and Prepayment
rates, which are used to calculate Stress Test Whole Loan cash flows
and Default losses. See section 3.6.3.7, Stress Test Whole Loan Cash
Flows, of this Appendix.
[c] The regression coefficients for each Loan Group will come
from one of three models. The choice of model will be determined by
the values of the single family product code and Government Flag in
the RBC Report. See section 3.6.3.4.3.2, Prepayment and Default
Rates and Performance Fractions, of this Appendix.
[d] Special Provision for Accounting Calculations. For
accounting calculations that require cash flows over the entire
remaining life of the instrument, Default and Prepayment rates for
months beyond the end of the Stress Test are held constant at their
values for month 120.
3.6.3.4.2 Single Family Default and Prepayment Inputs
The information in Table 3-34 is required for each single family
Loan Group:
Table 3-34--Single Family Default and Prepayment Inputs
----------------------------------------------------------------------------------------------------------------
Variable Description Source
----------------------------------------------------------------------------------------------------------------
PROD Mortgage Product Type RBC Report
----------------------------------------------------------------------------------------------------------------
A0 Age immediately prior to start of Stress RBC Report
Test, in months (weighted average for
Loan Group)
----------------------------------------------------------------------------------------------------------------
LTVORIG Loan-to-Value ratio at Origination RBC Report
(weighted average for Loan Group)
----------------------------------------------------------------------------------------------------------------
UPBORIG UPB at Origination (aggregate for Loan RBC Report
Group)
----------------------------------------------------------------------------------------------------------------
MIRORIG Mortgage Interest Rate at Origination RBC Report
(``Initial Rate'' for ARMs), decimal per
annum (weighted average for loan group)
----------------------------------------------------------------------------------------------------------------
UPB0 Unpaid Principal Balance immediately prior RBC Report
to start of Stress Test (aggregate for
Loan Group)
----------------------------------------------------------------------------------------------------------------
UPBm Unpaid Principal Balance in months m = section 3.6.3.3.4, Mortgage
1...RM Amortization Schedule Outputs
----------------------------------------------------------------------------------------------------------------
[[Page 47838]]
MIRm Mortgage Interest Rate in months m = section 3.6.3.3.4, Mortgage
1...RM (weighted average for Loan Group) Amortization Schedule Outputs
----------------------------------------------------------------------------------------------------------------
MCONm Conventional (30 Year Fixed-Rate) Mortgage section 3.3.2, Interest Rates
Rate series projected for months 1...RM Inputs, and section 3.3.4,
and for the 24 months prior to the start Interest Rates Outputs
of the Stress Test
----------------------------------------------------------------------------------------------------------------
T12Ym 1-year CMT series projected for months section 3.3.4, Interest Rates
1...120 of the Benchmark region and time Outputs
period
----------------------------------------------------------------------------------------------------------------
T120Ym 10-year CMT series projected for months section 3.3.4, Interest Rates
1...120 of the Benchmark region and time Outputs
period
----------------------------------------------------------------------------------------------------------------
HPGRq Vector of House Price Growth Rates for section 3.4.4, Property Valuation
quarters q = 1...40 of the Stress Period Outputs
----------------------------------------------------------------------------------------------------------------
CHPGF0LG Cumulative House Price Growth Factor since RBC Report
Loan Origination (weighted average for
Loan Group)
----------------------------------------------------------------------------------------------------------------
, HPI Dispersion Parameters for the Stress = 0.002977
Period (Benchmark Census Division, = -0.000024322
currently West South Central Census
Division, as published in the OFHEO House
Price Report for 1996:3)
----------------------------------------------------------------------------------------------------------------
IF Fraction (by UPB, in decimal form) of Loan RBC Report
Group backed by Investor-owned properties
----------------------------------------------------------------------------------------------------------------
RLSORIG Weighted average Relative Loan Size at RBC Report
Origination (Original UPB as a fraction
of average UPB for the state and
Origination Year of loan origination)
----------------------------------------------------------------------------------------------------------------
3.6.3.4.3 Single Family Default and Prepayment Procedures
3.6.3.4.3.1 Single Family Default and Prepayment Explanatory Variables
[a] Compute the explanatory variables for single family Default
and Prepayment in the seven steps as follows:
1. Calculate Aq, the loan Age in quarters, for quarter q:
[GRAPHIC] [TIFF OMITTED] TR13SE01.030
Where:
int means to round to the lower integer if the argument is not an
integer.
2. Calculate PNEQq, the Probability of Negative Equity in
quarter q:
[GRAPHIC] [TIFF OMITTED] TR13SE01.031
Where:
N designates the cumulative normal distribution function.
a. LTVq is evaluated for a quarter q as:
[GRAPHIC] [TIFF OMITTED] TR13SE01.032
The HPI at Origination is updated to the beginning of the Stress
Test using actual historical experience as measured by the OFHEO
HPI; and then updated within the Stress Test using House Price
Growth Factors from the Benchmark region and time period:
[GRAPHIC] [TIFF OMITTED] TR13SE01.033
Where:
UPBm=3q-3 = UPB for the month at the end of the quarter
prior to quarter q
b. Calculate the Dispersion of House Prices for loans in quarter
q of the Stress Test (q) as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.034
Where:
and are obtained from Table 3-34 and
[GRAPHIC] [TIFF OMITTED] TR13SE01.035
3. Calculate Bq, the Burnout factor in quarter q. A
loan's Prepayment incentive is ``burned out'' (i.e., reduced) if,
during at least two of the previous eight full quarters, the
borrower had, but did not take advantage of, an opportunity to
reduce his or her mortgage interest rate by at least two percentage
points. For this purpose, the mortgage interest rate is compared
with values of the Conventional Mortgage Rate (MCON) Index.
a. Compare mortgage rates for each quarter of the Stress Test
and for the eight quarters prior to the start of the stress test (q
= -7, -6, ...0, 1, ...30):
[GRAPHIC] [TIFF OMITTED] TR13SE01.036
Note:
For this purpose, MCONm is required for the 24 months
(eight quarters) prior to the start of the Stress Test. Also,
MIRm = MIRo for m 0.
b. Determine whether the loan is ``burned out'' in quarter q
(Burnout Flag, Bqf):
[GRAPHIC] [TIFF OMITTED] TR13SE01.037
Where:
q' = index variable for prior 8 quarters
c. Adjust for recently originated loans as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.038
4. Calculate RSq, the Relative Spread in quarter q, as
the average value of the monthly Relative Spread of the Original
mortgage interest rate to the Conventional (30-Year Fixed Rate)
Mortgage Rate series for the three months in the quarter.
[[Page 47839]]
Note:
Use the Current MIR for Fixed Rate Loans and the Original MIR
for Adjustable Rate Loans.
[GRAPHIC] [TIFF OMITTED] TR13SE01.039
If MIR = 0, then RSq = -0.20 for all q.
5. Calculate YCSq, the Yield Curve Slope in quarter q, as
the average of the monthly ratio of the 10-Year CMT to the One-Year
CMT for the three months in the quarter:
[GRAPHIC] [TIFF OMITTED] TR13SE01.040
6. Evaluate the Payment Shock Indicator (PSq) for ARMs
only:
[GRAPHIC] [TIFF OMITTED] TR13SE01.041
7. Evaluate the Initial Rate Effect Flag (IREFq) for ARMS
only:
[GRAPHIC] [TIFF OMITTED] TR13SE01.042
3.6.3.4.3.2 Prepayment and Default Rates and Performance Fractions
[a] Calculate Prepayment and Default Rates and Performance
Fractions using the following five steps:
1. Compute the logits for Default and Prepayment using the formulas
for simultaneous processes using inputs from Table 3-34 and
explanatory variable coefficients in Table 3-35.
Note:
BCalLTV is the LTV-specific constant used to
calibrate the Default rates to the BLE.
[GRAPHIC] [TIFF OMITTED] TR13SE01.043
Table 3-35--Coefficients for Single Family Default and Prepayment Explanatory Variable
----------------------------------------------------------------------------------------------------------------
30-Year Fixed-Rate Loans Adjustable-Rate Loans Other Fixed-Rate Loans
---------------------------- (ARMs) ---------------------------
----------------------------
Explanatory Variable (V) Default Pre- payment Default Pre- payment Default Pre- payment
Weight Weight Weight Weight Weight Weight
(v) (v) (v) (v) (v) (v)
----------------------------------------------------------------------------------------------------------------
Aq
0 Aq > 4 -0.6276 -0.6122 -0.7046 -0.5033 -0.7721 -0.6400
----------------------------------------------------------------------------------------------------------------
5 Aq > 8 -0.1676 0.1972 -0.2259 0.1798 -0.2738 0.1721
----------------------------------------------------------------------------------------------------------------
9 Aq > 12 -0.05872 0.2668 0.01504 0.2744 -0.09809 0.2317
----------------------------------------------------------------------------------------------------------------
13 Aq > 16 0.07447 0.2151 0.2253 0.2473 0.1311 0.1884
----------------------------------------------------------------------------------------------------------------
17 Aq > 20 0.2395 0.1723 0.3522 0.1421 0.3229 0.1900
----------------------------------------------------------------------------------------------------------------
21 Aq > 24 0.2773 0.2340 0.4369 0.1276 0.3203 0.2356
----------------------------------------------------------------------------------------------------------------
25 Aq > 36 0.2740 0.1646 0.2954 0.1098 0.3005 0.1493
----------------------------------------------------------------------------------------------------------------
37 Aq > 48 0.1908 -0.2318 0.06902 -0.1462 0.2306 -0.2357
----------------------------------------------------------------------------------------------------------------
49 Aq -0.2022 -0.4059 -0.4634 -0.4314 -0.1614 -0.2914
----------------------------------------------------------------------------------------------------------------
LTVORIG
LTVORIG > 60 -1.150 0.04787 -1.303 0.08871 -1.280 0.02309
----------------------------------------------------------------------------------------------------------------
60 LTVORIG > 70 -0.1035 -0.03131 -0.1275 -0.005619 -0.06929 -0.02668
----------------------------------------------------------------------------------------------------------------
70 LTVORIG > 75 0.5969 -0.09885 0.4853 -0.09852 0.6013 -0.05446
----------------------------------------------------------------------------------------------------------------
75 LTVORIG > 80 0.2237 -0.04071 0.1343 -0.03099 0.2375 -0.03835
----------------------------------------------------------------------------------------------------------------
80 LTVORIG > 90 0.2000 -0.004698 0.2576 0.004226 0.2421 -0.01433
----------------------------------------------------------------------------------------------------------------
90 LTVORIG 0.2329 0.1277 0.5528 0.04220 0.2680 0.1107
----------------------------------------------------------------------------------------------------------------
PNEQQ
0 PNEQq > 0.05 -1.603 0.5910 -1.1961 0.4607 -1.620 0.5483
----------------------------------------------------------------------------------------------------------------
0.05 PNEQq > 0.1 -0.5241 0.3696 -0.3816 0.2325 -0.5055 0.3515
----------------------------------------------------------------------------------------------------------------
0.1 PNEQq > 0.15 -0.1805 0.2286 -0.1431 0.1276 -0.1249 0.2178
----------------------------------------------------------------------------------------------------------------
0.15 PNEQq > 0.2 0.07961 -0.02000 -0.04819 0.03003 0.07964 -0.02137
----------------------------------------------------------------------------------------------------------------
0.2 PNEQq > 0.25 0.2553 -0.1658 0.2320 -0.1037 0.2851 -0.1540
----------------------------------------------------------------------------------------------------------------
0.25 PNEQq > 0.3 0.5154 -0.2459 0.2630 -0.1829 0.4953 -0.2723
----------------------------------------------------------------------------------------------------------------
[[Page 47840]]
0.3 PNEQq > 0.35 0.6518 -0.2938 0.5372 -0.2075 0.5979 -0.2714
----------------------------------------------------------------------------------------------------------------
0.35 PNEQq 0.8058 -0.4636 0.7368 -0.3567 0.7923 -0.3986
----------------------------------------------------------------------------------------------------------------
Bq
1.303 -0.3331 0.8835 -0.2083 1.253 -0.3244
----------------------------------------------------------------------------------------------------------------
RLS
0 RLSORIG > 0.4 ............ -0.5130 ............ -0.4765 ............ -0.4344
----------------------------------------------------------------------------------------------------------------
0.4 RLSORIG > 0.6 ............ -0.3264 ............ -0.2970 ............ -0.2852
----------------------------------------------------------------------------------------------------------------
0.6 RLSORIG > 0.75 ............ -0.1378 ............ -0.1216 ............ -0.1348
----------------------------------------------------------------------------------------------------------------
0.75 RLSORIG > 1.0 ............ 0.03495 ............ 0.04045 ............ 0.01686
----------------------------------------------------------------------------------------------------------------
1.0 RLSORIG > 1.25 ............ 0.1888 ............ 0.1742 ............ 0.1597
----------------------------------------------------------------------------------------------------------------
1.25 RLSORIG > 1.5 ............ 0.3136 ............ 0.2755 ............ 0.2733
----------------------------------------------------------------------------------------------------------------
1.5 RLSORIG ............ 0.4399 ............ 0.4049 ............ 0.4045
----------------------------------------------------------------------------------------------------------------
IF 0.4133 -0.3084 0.6419 -0.3261 0.4259 -0.3035
----------------------------------------------------------------------------------------------------------------
RSq
RSq > -0.20 ............ -1.368 ............ -0.5463 ............ -1.195
----------------------------------------------------------------------------------------------------------------
-0.20 RSq > -0.10 ............ -1.023 ............ -0.4560 ............ -0.9741
----------------------------------------------------------------------------------------------------------------
-0.10 RSq > 0 ............ -0.8078 ............ -0.4566 ............ -0.7679
----------------------------------------------------------------------------------------------------------------
0.10 RSq > 0.10 ............ -0.3296 ............ -0.3024 ............ -0.2783
----------------------------------------------------------------------------------------------------------------
0 RSq > 0.20 ............ 0.8045 ............ 0.3631 ............ 0.7270
----------------------------------------------------------------------------------------------------------------
0.20 RSq > 0.30 ............ 1.346 ............ 0.7158 ............ 1.229
----------------------------------------------------------------------------------------------------------------
0.30 RSq ............ 1.377 ............ 0.6824 ............ 1.259
----------------------------------------------------------------------------------------------------------------
PSq
PSq > -0.20 ............ ............ 0.08490 0.6613 ............ ............
----------------------------------------------------------------------------------------------------------------
-0.20 PSq > -0.10 ............ ............ 0.3736 0.4370 ............ ............
----------------------------------------------------------------------------------------------------------------
-0.10 PSq > 0 ............ ............ 0.2816 0.2476 ............ ............
----------------------------------------------------------------------------------------------------------------
0 PSq > 0.10 ............ ............ 0.1381 0.1073 ............ ............
----------------------------------------------------------------------------------------------------------------
0.10 PSq > 0.20 ............ ............ -0.1433 -0.3516 ............ ............
----------------------------------------------------------------------------------------------------------------
0.20 PSq > 0.30 ............ ............ -0.2869 -0.5649 ............ ............
----------------------------------------------------------------------------------------------------------------
0.30 PSq ............ ............ -0.4481 -0.5366 ............ ............
----------------------------------------------------------------------------------------------------------------
YCSq
YCSq 1.0 ............ -0.2582 ............ -0.2947 ............ -0.2917
----------------------------------------------------------------------------------------------------------------
1.0 YCSq 1.2 ............ -0.02735 ............ -0.1996 ............ -0.01395
----------------------------------------------------------------------------------------------------------------
1.2 YCSq 1.5 ............ -0.04099 ............ 0.03356 ............ -0.03796
----------------------------------------------------------------------------------------------------------------
1.5 YCSq ............ 0.3265 ............ 0.4608 ............ 0.3436
----------------------------------------------------------------------------------------------------------------
IREFq ............ ............ 0.1084 -0.01382 ............ ............
----------------------------------------------------------------------------------------------------------------
PROD
ARMS ............ ............ 0.8151 0.2453 ............ ............
----------------------------------------------------------------------------------------------------------------
Balloons Loans ............ ............ ............ ............ 1.253 0.9483
----------------------------------------------------------------------------------------------------------------
15-Year FRMs ............ ............ ............ ............ -1.104 0.07990
----------------------------------------------------------------------------------------------------------------
20-Year FRMs ............ ............ ............ ............ -0.5834 0.06780
----------------------------------------------------------------------------------------------------------------
Government Loans ............ ............ ............ ............ 0.9125 -0.5660
----------------------------------------------------------------------------------------------------------------
[[Page 47841]]
BCalLTV
LTVORIG > 60 2.045 ............ 2.045 ............ 2.045 ............
----------------------------------------------------------------------------------------------------------------
60 LTVORIG > 70 0.3051 ............ 0.3051 ............ 0.3051 ............
----------------------------------------------------------------------------------------------------------------
70 LTVORIG > 75 -0.07900 ............ -0.07900 ............ -0.07900 ............
----------------------------------------------------------------------------------------------------------------
75 LTVORIG > 80 -0.05519 ............ -0.05519 ............ -0.05519 ............
----------------------------------------------------------------------------------------------------------------
80 LTVORIG > 90 -0.1838 ............ -0.1838 ............ -0.1838 ............
----------------------------------------------------------------------------------------------------------------
90 LTVORIG 0.2913 ............ 0.2913 ............ 0.2913 ............
----------------------------------------------------------------------------------------------------------------
Intercept (0, -6.516 -4.033 -6.602 -3.965 -6.513 -3.949
0)
----------------------------------------------------------------------------------------------------------------
2. The choice of coefficients from Table 3-35 will be governed by
the single family product code and Government Flag, according to
Table 3-36.
Table 3-36--Single Family Product Code Coefficient Mapping
------------------------------------------------------------------------
Single Family Product Code Model Coefficient Applied
------------------------------------------------------------------------
Non-Government Loans
------------------------------------------------------------------------
Fixed Rate 30YR 30-Year FRMs
------------------------------------------------------------------------
Fixed Rate 20YR 20-Year FRMs
------------------------------------------------------------------------
Fixed Rate 15YR 15-Year FRMs
------------------------------------------------------------------------
5-Year Fixed Rate Balloon Balloon Loans
------------------------------------------------------------------------
7-Year Fixed Rate Balloon Balloon Loans
------------------------------------------------------------------------
10-Year Fixed Rate Balloon Balloon Loans
------------------------------------------------------------------------
15-Year Fixed Rate Balloon Balloon Loans
------------------------------------------------------------------------
Adjustable Rate ARMs
------------------------------------------------------------------------
Second Lien Balloon Loans
------------------------------------------------------------------------
Other Balloon Loans
------------------------------------------------------------------------
Government Loans
------------------------------------------------------------------------
Government Flag Model Coefficient Applied
------------------------------------------------------------------------
All government loans except for Government Loans
ARMs
------------------------------------------------------------------------
Government ARMs ARMs
------------------------------------------------------------------------
3. Compute Quarterly Prepayment and Default Rates (QPR, QDR) from
the logistic expressions as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.044
4. Convert quarterly rates to monthly rates using the following
formulas for simultaneous processes. The quarterly rate for q = 1
gives the monthly rate for months m = 1,2,3, and so on through q =
40:
[GRAPHIC] [TIFF OMITTED] TR13SE01.045
[[Page 47842]]
5. Calculate Defaulting Fraction (DEF), Prepaying Fraction (PRE),
and Performing Fraction (PERF) of the Initial Loan Group. Initially
(at the beginning of the Stress Test), all loans are assumed to be
performing, i.e. PERF0 = 1.0. For each month m = 1...RM,
calculate the following quantities. Note: For m > 120, use and
MPR120 and MDR120:
[GRAPHIC] [TIFF OMITTED] TR13SE01.046
3.6.3.4.4 Single Family Default and Prepayment Outputs
Single family Default and Prepayment outputs are set forth in
Table 3-37. Prepayment, Default and Performing Fractions for single
family loans for months m = 1...RM are used in section 3.6.3.6,
Calculation of Single Family and Multifamily Mortgage Losses; and
section 3.6.3.7, Stress Test Whole Loan Cash Flows, of this
Appendix. Quarterly LTV ratios are used in section 3.6.3.6.2.3,
Single Family Gross Loss Severity Procedures, of this Appendix.
Table 3-37--Single Family Default and Prepayment Outputs
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
LTVq Current Loan-to-Value ratio in quarter
q = 1...40
------------------------------------------------------------------------
PREmSF Prepaying Fraction of Initial Loan
Group in month m = 1...RM (single
family Loans)
------------------------------------------------------------------------
DEFmSF Defaulting Fraction of Initial Loan
Group in month m = 1...RM (single
family Loans)
------------------------------------------------------------------------
PERFmSF Performing Fraction of Initial original
Loan Group in month m = 1...RM (single
family loans)
------------------------------------------------------------------------
3.6.3.5 Multifamily Default and Prepayment Rates
3.6.3.5.1 Multifamily Default and Prepayment Rates Overview
[a] The Stress Test projects conditional Default and Prepayment
rates for each multifamily Loan Group for each month of the Stress
Period. Computing Default rates for a Loan Group requires
information on the Loan Group characteristics at the beginning of
the Stress Test and the economic conditions of the Stress Period--
interest rates (section 3.3 of this Appendix), vacancy rates and
rent growth rates (section 3.4 of this Appendix). These input data
are used to create values for the explanatory variables in the
Multifamily Default component.
[b] Explanatory Variables for Default Rates. Ten explanatory
variables are used as specified in the equations section
3.6.3.5.3.1, of this Appendix, to determine Default rates for
multifamily loans: Mortgage Age, Mortgage Age Squared, New Book
indicator, New Book--ARM interaction, New Book--Balloon Loan
interaction, Ratio Update Flag, current Debt-Service Coverage Ratio,
Underwater Current Debt-Service Coverage indicator, Loan-To-Value
Ratio at origination/acquisition, and a Balloon Maturity indicator.
Regression coefficients (weights) are associated with each variable.
All of this information is used to compute conditional annual
Default rates throughout the Stress Test. The annualized Default
rates are converted to monthly conditional Default rates and are
used together with monthly conditional Prepayment rates to calculate
Stress Test Whole Loan Cash Flows. (See section 3.6.3.7, Stress Test
Whole Loan Cash Flows, of this appendix).
[c] Specification of Multifamily Prepayment Rates. Multifamily
Prepayment rates are not generated by a statistical model but follow
a set of Prepayment rules that capture the effect of yield
maintenance, Prepayment penalties and other mechanisms that
effectively curtail or eliminate multifamily Prepayments for a
specified period of time.
[d] Special Provision for Accounting Calculations. For
accounting calculations, which require cash flows over the entire
remaining life of the instrument, Default and Prepayment rates for
months beyond the end of the Stress Test are held constant at their
values for month 120.
3.6.3.5.2 Multifamily Default and Prepayment Inputs
The information in Table 3-38 is required for each multifamily
Loan Group:
Table 3-38--Loan Group Inputs for Multifamily Default and Prepayment Calculations
----------------------------------------------------------------------------------------------------------------
Variable Description Source
----------------------------------------------------------------------------------------------------------------
Mortgage Product Type RBC Report
----------------------------------------------------------------------------------------------------------------
A0 Age immediately prior to start of Stress RBC Report
Test, in months (weighted average for Loan
Group)
----------------------------------------------------------------------------------------------------------------
NBF New Book Flag RBC Report
----------------------------------------------------------------------------------------------------------------
RUF Ratio Update Flag RBC Report
----------------------------------------------------------------------------------------------------------------
LTVORIG Loan-to-Value ratio at loan Origination RBC Report
----------------------------------------------------------------------------------------------------------------
DCR0 Debt Service Coverage Ratio at the start of RBC Report
the Stress Test
----------------------------------------------------------------------------------------------------------------
PMT0 Amount of the mortgage Payment (principal and RBC Report
interest) prior to the start of the Stress
Test, or first Payment for new loans
(aggregate for Loan Group)
----------------------------------------------------------------------------------------------------------------
PPEM Prepayment Penalty End Month number in the RBC Report
Stress Test (weighted average for Loan
Group)
----------------------------------------------------------------------------------------------------------------
RM Remaining term to Maturity in months (i.e., RBC Report
number of contractual payments due between
the start of the Stress Test and the
contractual maturity date of the loan)
(weighted average for Loan Group)
----------------------------------------------------------------------------------------------------------------
RGRm Benchmark Rent Growth for months m = 1...120 section 3.4.4, Property
of the Stress Test Valuation Outputs
----------------------------------------------------------------------------------------------------------------
RVRm Benchmark Vacancy Rates for months m = section 3.4.4, Property
1...120 of the Stress Test Valuation Outputs
----------------------------------------------------------------------------------------------------------------
PMTm Scheduled Payment for months m = 1...RM section 3.6.3.3.4, Mortgage
Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
OE Operating expenses as a share of gross fixed decimal from
potential rents (0.472) Benchmark region and time
period
----------------------------------------------------------------------------------------------------------------
[[Page 47843]]
RVRo Initial rental vacancy rate 0.0623
----------------------------------------------------------------------------------------------------------------
3.6.3.5.3 Multifamily Default and Prepayment Procedures
3.6.3.5.3.1 Explanatory Variables
[a] Compute the explanatory variables for multifamily Default
and Prepayment in five steps as follows:
1. Calculate Loan Age in Years for months m = 0...120 of the Stress
Test (AYm):
[GRAPHIC] [TIFF OMITTED] TR13SE01.047
Where:
A0 + m is Loan Age in months at the beginning of month m
of the Stress Test.
Note:
AYm is calculated for each month m, whereas the
corresponding Age variable for single family Loans Aq is
calculated only quarterly.
2. Assign Product and Ratio Update Flags (NBF, NAF, NBLF, RUF).
Note: these values do not change over time for a given Loan Group.
a. New Book Flag (NBF):
NBF = 1 for Fannie Mae loans acquired after 1987 and Freddie Mac
loans acquired after 1992, except for loans that were refinanced to
avoid a Default on a loan originated or acquired earlier.
NBF = 0 otherwise.
b. New ARM Flag (NAF):
[GRAPHIC] [TIFF OMITTED] TR13SE01.048
Where:
ARMF = 1 for ARMs (including Balloon ARMs)
ARMF = 0 otherwise
c. New Balloon Flag (NBLF):
[GRAPHIC] [TIFF OMITTED] TR13SE01.049
Where:
BALF = 1 for Fixed Rate Balloon Loans
BALF = 0 otherwise
d. Ratio Update Flag (RUF):
RUF = 1 for loans whose LTV and DCR were updated at origination or
Enterprise acquisition
RUF = 0 otherwise.
3. Calculate Debt Service Coverage Ratio in month m
(DCRm):
The standard definition of Debt Service Coverage Ratio is
current net operating income divided by current mortgage payment.
However, for the Stress Test, update DCRm each month from
the prior month's value using Rent Growth Rates (RGRm)
and Rental Vacancy Rates (RVRm) starting with
DCRm from Table 3-38, as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.051
4. Assign Underwater Debt-Service Coverage Flag
(UWDCRFm):
UWDCRFm = 1 if DCRm 1 in month m
UWDCRFm = 0 otherwise.
5. Assign Balloon Maturity Flag (BMFm) for any Balloon
Loan that is within twelve months of its maturity date:
[GRAPHIC] [TIFF OMITTED] TR13SE01.053
3.6.3.5.3.2 Default and Prepayment Rates and Performance Fractions
[a] Compute Default and Prepayment Rates and Performance
Fractions for multifamily loans in the following four steps:
1. Compute the logits for multifamily Default using inputs from
Table 3-38 and coefficients from Table 3-39. For indexing purposes,
the Default rate for a period m is the likelihood of missing the
m\th\ payment; calculate its corresponding logit
(Xm) based on Loan Group characteristics as of
the period prior to m, i.e. prior to making the m\th\ payment.
[GRAPHIC] [TIFF OMITTED] TR13SE01.054
Table 3-39--Explanatory Variable Coefficients for Multifamily Default
------------------------------------------------------------------------
Default
Explanatory variable (V) weight
(v)
------------------------------------------------------------------------
AY 0.5171
------------------------------------------------------------------------
AY\2\ -0.02788
------------------------------------------------------------------------
NBF -2.041
------------------------------------------------------------------------
NAF 1.694
------------------------------------------------------------------------
NBLF 0.8191
------------------------------------------------------------------------
RUF -0.5929
------------------------------------------------------------------------
DCR -2.495
------------------------------------------------------------------------
UWDCRF 1.488
------------------------------------------------------------------------
LTV 0.8585
------------------------------------------------------------------------
BMF 1.541
------------------------------------------------------------------------
Intercept (0) -4.452
------------------------------------------------------------------------
2. Compute Annual Prepayment Rate (APR) and Annual Default Rate
(ADR) as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.055
APRm is a constant, determined as follows:
a. For the up-rate scenario, APRm = 0 for all months
m
b. For the down-rate scenario,
APRm = 2 percent during the Prepayment penalty
period (i.e., when m PPEM)
APRm = 25 percent after the Prepayment penalty
period (i.e., when m > PPEM)
3. Convert annual Prepayment and Default rates to monthly rates (MPR
and MDR) using the following formulas for simultaneous processes:
[GRAPHIC] [TIFF OMITTED] TR13SE01.057
4. Calculate Defaulting Fraction (DEFm), Prepaying
Fraction (PREm), and Performing Fraction
(PERFm) of the Initial Loan Group for each month m =
1...RM. Initially (immediately prior to the beginning of the Stress
Test), all loans are assumed to be performing, i.e. PERF0
= 1.0. Note: For m> 120, use MPR120 and
MDR120.
[[Page 47844]]
[GRAPHIC] [TIFF OMITTED] TR13SE01.058
3.6.3.5.4 Multifamily Default and Prepayment Outputs
[a] Multifamily Default and Prepayment Outputs are set forth in
Table 3-40.
Table 3-40--Multifamily Default and Prepayment Outputs
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
PREm\MF\ Prepaying Fraction of initial
Loan Group in month m=1...RM
(multifamily Loans)
------------------------------------------------------------------------
DEFm\MF\ Defaulting Fraction of initial
Loan Group in month m=1...RM
(multifamily Loans)
------------------------------------------------------------------------
PERFm\MF\ Performing Fraction of initial
Loan Group in month m=1...RM
(multifamily Loans)
------------------------------------------------------------------------
[b] Multifamily monthly Prepayment Fractions
(PERFmMF) and monthly Default Fractions
(DEFmMF) for months m=1...RM are used in
section 3.6.3.6, Calculation of Single Family and Multifamily
Mortgage Losses; section 3.6.3.7, Stress Test Whole Loan Cash Flows,
and section 3.6.3.8, Whole Loan Accounting Flows, of this Appendix.
3.6.3.6 Calculation of Single Family and Multifamily Mortgage Losses
3.6.3.6.1 Calculation of Single Family and Multifamily Mortgage Losses
Overview
[a] Definition. Loss Severity is the net cost to an Enterprise
of a loan Default. Though losses may be associated with delinquency,
loan restructuring and/or modification and other loss mitigation
efforts, foreclosures are the only loss events modeled during the
Stress Test.
[b] Calculation. The Loss Severity rate is expressed as a
fraction of the Unpaid Principal Balance (UPB) at the time of
Default. The Stress Test calculates Loss Severity rates for each
Loan Group for each month of the Stress Period. Funding costs (and
offsetting revenues) of defaulted loans are captured by discounting
the Loss Severity elements using a cost-of-funds interest rate that
varies during the Stress Period. Table 3-41 specifies the Stress
Test Loss Severity timeline. Loss Severity rates also depend upon
the application of Credit Enhancements and the credit ratings of
enhancement providers.
Table 3-41--Loss Severity Event Timing
------------------------------------------------------------------------
Month Event
------------------------------------------------------------------------
1 First missed payment
------------------------------------------------------------------------
4 ( = MQ) Loan is repurchased from
securitized pool and UPB is
passed through to MBS
investors (Sold Loans only)
------------------------------------------------------------------------
13 ( = MFSF) Single family foreclosure
------------------------------------------------------------------------
18 ( = MFMF) Multifamily foreclosure
------------------------------------------------------------------------
20 ( = MFSF+ MRSF) Single family property
disposition
------------------------------------------------------------------------
31 ( = MFMF+MRMF) Multifamily property
disposition
------------------------------------------------------------------------
[c] Timing of the Default Process. Mortgage Defaults are modeled
as follows: defaulting loans enter foreclosure after a number of
months (MQ, Months in Delinquency) and are foreclosed upon several
months later. MF (Months in Foreclosure) is the total number of
missed payments. Upon completion of foreclosure, the loan as such
ceases to exist and the property becomes Real Estate Owned by the
lender (REO). After several more months (MR, Months in REO), the
property is sold. Foreclosure expenses are paid and MI proceeds
(and, for multifamily loans, loss sharing proceeds) are received
when foreclosure is completed. REO expenses are paid, and sales
proceeds and other Credit Enhancements are received, when the
property is sold. These timing differences are not modeled
explicitly in the cash flows, but their economic effect is taken
into account by present-valuing the default-related cash flows to
the month of Default.
[d] Gross Loss Severity, Credit Enhancement, and Net Loss
Severity. The calculation of mortgage losses is divided into three
parts. First, Gross Loss Severity is determined by expressing the
principal loss plus unpaid interest plus expenses as a percentage of
the loan UPB at the time of Default (section 3.6.3.6.2, Single
Family Gross Loss Severity, and section 3.6.3.6.3, Multifamily Gross
Loss Severity, of this Appendix). Second, Credit Enhancements (CEs)
are applied according to their terms to offset losses on loans that
are covered by one or more CE arrangements (section 3.6.3.6.4,
Mortgage Credit Enhancement, of this Appendix). Finally, to account
for the timing of these different cash flows, net losses are
discounted back to the month in which the Default initially occurred
(section 3.6.3.6.5, Single Family and Multifamily Net Loss Severity,
of this Appendix).
3.6.3.6.2 Single Family Gross Loss Severity
3.6.3.6.2.1 Single Family Gross Loss Severity Overview
The Loss Severity calculation adds the discounted present value
of various costs and offsetting revenues associated with the
foreclosure of single family properties, expressed as a fraction of
UPB on the date of Default. The loss elements are:
[a] Unpaid Principal Balance. Because all Loss Severity elements
are expressed as a fraction of Default date UPB, the outstanding
loan balance is represented as 1.
[b] Unpaid Interest. Unpaid interest at the Mortgage Interest
Rate is included in the MI claim amount. Unpaid interest at the
Pass-Through Rate must be paid to MBS holders until the Defaulted
loan is repurchased from the MBS pool.
[c] Foreclosure Expenses and REO Expenses. Foreclosure expenses
are reimbursed by MI. REO expenses are incurred in connection with
the maintenance and sale of a property after foreclosure is
completed. Stress Test values for these quantities are derived from
historical Enterprise REO experience.
[d] Net Recovery Proceeds from REO sale (RP). This amount is
less than the sale price for ordinary properties as predicted by the
HPI, because of the distressed nature of the sale.
3.6.3.6.2.2 Single Family Gross Loss Severity Inputs
The inputs in Table 3-42 are used to compute Gross Loss Severity
for single family loans:
Table 3-42--Loan Group Inputs for Gross Loss Severity
----------------------------------------------------------------------------------------------------------------
Variable Description Definition or Source
----------------------------------------------------------------------------------------------------------------
Government Flag RBC Report
----------------------------------------------------------------------------------------------------------------
MQ Months Delinquent: time during which 4 for sold loans
Enterprise pays delinquent loan interest to 0 otherwise
MBS holders
----------------------------------------------------------------------------------------------------------------
MF Months to Foreclosure: number of missed 13 months
payments through completion of foreclosure
----------------------------------------------------------------------------------------------------------------
MR Months from REO acquisition to REO 7 months
disposition
----------------------------------------------------------------------------------------------------------------
F Foreclosure Costs as a decimal fraction of 0.037
Defaulted UPB
----------------------------------------------------------------------------------------------------------------
R REO Expenses as a decimal fraction of 0.163
Defaulted UPB
----------------------------------------------------------------------------------------------------------------
[[Page 47845]]
DRm Discount Rate in month m (decimal per annum) 6-month Enterprise Cost of
Funds from section 3.3,
Interest Rates
----------------------------------------------------------------------------------------------------------------
LTVq Current LTV in quarter q = 1...40 section 3.6.3.4.4, Single
Family Default and
Prepayment Outputs
----------------------------------------------------------------------------------------------------------------
MIRm Mortgage Interest Rate in month m (decimal section 3.6.3.3.4, Mortgage
per annum) Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
PTRm Pass-Through Rate applicable to payment due section 3.6.3.3.4, Mortgage
in month m (decimal per annum) Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
RR Recovery Rate for Defaulted loans in the BLE, 0.61
as a percent of predicted house price using
HPI (decimal)
----------------------------------------------------------------------------------------------------------------
3.6.3.6.2.3 Single Family Gross Loss Severity Procedures
[a] Calculate single family gross Loss Severity using the
following three steps:
1. Compute REO Proceeds in month m (RPm) as a fraction of
Defaulted UPB:
[GRAPHIC] [TIFF OMITTED] TR13SE01.059
2. Compute MI Claim Amount on loans that Defaulted in month m
(CLMmMI) as a fraction of Defaulted UPB:
[GRAPHIC] [TIFF OMITTED] TR13SE01.060
Where:
0.67 = FHA reimbursement rate on foreclosure-related expenses
0.75 = adjustment to reflect that FHA reimbursement on unpaid
interest is at a government debenture rate, not MIR.
3. Compute Gross Loss Severity of loans that Defaulted in month m
(GLm) as a fraction of Defaulted UPB:
[GRAPHIC] [TIFF OMITTED] TR13SE01.061
3.6.3.6.2.4 Single Family Gross Loss Severity Outputs
The single family Gross Loss Severity outputs in Table 3-43 are
used in the Credit Enhancement calculations in section 3.6.3.6.4 of
this Appendix.
Table 3-43--Single Family Gross Loss Severity Outputs
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
GLSm Gross Loss Severity for loans that
defaulted in month m = 1...120
------------------------------------------------------------------------
CLMmMI MI claim on account of loans that
defaulted in month m = 1...120
------------------------------------------------------------------------
RPm REO Proceeds on account of loans that
defaulted in month m = 1...120
------------------------------------------------------------------------
3.6.3.6.3 Multifamily Gross Loss Severity
3.6.3.6.3.1 Multifamily Gross Loss Severity Overview
The multifamily Loss Severity calculation adds the discounted
present value of various costs and offsetting revenues associated
with the foreclosure of multifamily properties, expressed as a
fraction of Defaulted UPB. The loss elements are:
[a] Unpaid Principal Balance (UPB). Because all Loss Severity
elements are expressed as a fraction of Default date UPB, the
outstanding loan balance is represented as 1.
[b] Unpaid Interest. Unpaid interest at the Net Yield Rate is
included in the Loss Sharing Claim amount. Unpaid interest at the
Pass-Through Rate must be paid to MBS holders until the defaulted
loan is repurchased from the MBS pool.
[c] Net REO Holding Costs (RHC). Foreclosure costs, including
attorneys fees and other liquidation expenses are incurred between
the date of Default and the date of foreclosure completion (REO
acquisition). Operating and capitalized expenses are incurred and
rental and other income are received between REO acquisition and REO
disposition. As a result, half of the Net REO Holding Costs (RHC)
are expensed at REO acquisition and the remainder are expensed at
REO disposition.
[d] Net Proceeds from REO sale (RP). The gross sale price of the
REO less all costs associated with the disposition of the REO asset
are discounted from the date of REO sale.
3.6.3.6.3.2 Multifamily Gross Loss Severity Inputs
The inputs in Table 3-44 are used to compute Gross Loss Severity
for multifamily Loans:
Table 3-44--Loan Group Inputs for Multifamily Gross Loss Severity
----------------------------------------------------------------------------------------------------------------
Variable Description Value or Source
----------------------------------------------------------------------------------------------------------------
Government Flag RBC Report
----------------------------------------------------------------------------------------------------------------
DRm Discount Rate in month m (decimal per annum) 6-month Enterprise Cost of
Funds from Section 3.3,
Interest Rates
----------------------------------------------------------------------------------------------------------------
MQ Time during which delinquent loan interest is 4 for sold loans
passed-through to MBS holders 0 otherwise
----------------------------------------------------------------------------------------------------------------
[[Page 47846]]
PTRm Pass Through Rate applicable to payment due section 3.6.3.3.4, Mortgage
in month m (decimal per annum) Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
NYRm Net Yield Rate applicable to payment due in section 3.6.3.3.4, Mortgage
month m (decimal per annum) Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
RHC Net REO holding costs as a decimal fraction 0.1333
of Defaulted UPB
----------------------------------------------------------------------------------------------------------------
MF Time from Default to completion of 18 months
foreclosure (REO acquisition)
----------------------------------------------------------------------------------------------------------------
MR Months from REO acquisition to REO 13 months
disposition
----------------------------------------------------------------------------------------------------------------
RP REO proceeds as a decimal fraction of 0.5888
Defaulted UPB
----------------------------------------------------------------------------------------------------------------
3.6.3.6.3.3 Multifamily Gross Loss Severity Procedures
[a] Calculate multifamily gross loss severity in the following
two steps:
1. For Conventional Loans, compute the Loss Sharing Claim Amount
(CLMm\LSA\) and Gross Loss (GLm) on loans that
Defaulted in month m, as a fraction of Defaulted UPB:
[GRAPHIC] [TIFF OMITTED] TR13SE01.062
2. For FHA-insured (i.e., government) multifamily Loans, separate
Gross Loss Severity and Credit Enhancement calculations are not
necessary. Net Loss Severity is determined explicitly in section
3.6.3.6.5, Single Family and Multifamily Net Loss Severity, of this
Appendix).
3.6.3.6.3.4 Multifamily Gross Loss Severity Outputs
Multifamily Gross Loss Severity Outputs in Table 3-45 are used
in the Credit Enhancements Calculations section 3.6.3.6.4, of this
Appendix.
Table 3-45--Multifamily Gross Loss Severity Outputs for use in Credit
Enhancement Calculations
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
GLSm Gross Loss Severity for loans
that Defaulted in month m =
1...120
------------------------------------------------------------------------
CLMm\LSA\ Loss Sharing Claim on account
of loans that Defaulted in
month m = 1...120
------------------------------------------------------------------------
3.6.3.6.4 Mortgage Credit Enhancement
3.6.3.6.4.1 Mortgage Credit Enhancement Overview
[a] Types of Mortgage Credit Enhancements. Credit Enhancements
(CE) reimburse losses on individual loans. The CE most often
utilized by the Enterprises at the present time is primary Mortgage
Insurance (MI) including both private and government MI or loan
guarantees (e.g. FHA, VA), which pays claims up to a given limit on
each loan. Most other types of CE do not limit the amount payable on
each loan individually, but do limit the aggregate amount available
under a given CE arrangement or Contract. These two types of CE must
be computed differently. To denote this distinction, this Appendix
will refer to ``Loan Limit'' and ``Aggregate Limit'' CE types. Loan
Limit CE includes Mortgage Insurance for single family loans and
Loss-Sharing Arrangements (LSA) for multifamily loans. Aggregate
Limit CE includes Pool Insurance, Spread Accounts, Letters of
Credit, Cash or Collateral Accounts, and Subordination Agreements.
For operational convenience in the Stress Test, the Aggregate Limit
classification also includes Unlimited Recourse, which has neither
loan-level nor aggregate-level coverage limits, and Modified Pool
Insurance, Limited Recourse, Limited Indemnification and FHA risk-
sharing, which may have both loan-level and aggregate-level coverage
limits.
[b] Loan Limit Credit Enhancements. Loan Limit Credit
Enhancements are applied to every covered loan individually, without
regard to how much has been paid on any other covered loan. For
example, an MI policy covers losses on an individual loan up to a
specified limit. If every loan with MI were to Default, every claim
would be payable regardless of the total outlay on the part of the
MI provider. Loss Sharing Arrangements on multifamily loans operate
the same way.
[c] Aggregate Limit Credit Enhancements. Aggregate Limit Credit
Enhancements cover a group of loans on an aggregate basis. In most
such arrangements, the coverage for any individual loan is
unlimited, except that the total outlay by the provider cannot
exceed a certain aggregate limit. Thus, the amount of Aggregate
Limit coverage available to an individual loan depends, in practice,
on how much has been paid on all previous claims under the specified
Contract.
[d] Credit Enhancement Counterparty Defaults. CE payments from a
rated counterparty are subject to Haircuts to simulate counterparty
failures during the Stress Test. These Haircuts are based on the
rating of the counterparty or guarantor immediately prior to the
Stress Test, and are applied each month as described in section 3.5,
Counterparty Defaults, of this Appendix.
[e] Stress Test Application of Credit Enhancement. The Stress
Test calculates mortgage cash flows for aggregated Loan Groups,
within which individual loans are assumed to have identical
characteristics, and therefore are not differentiated in the
computations. However, a single Loan Group may include loans with
Loan Limit CE and/or one or more types of Aggregate Limit CE.
Additionally, this coverage may come from a rated provider or from
cash or cash-equivalent collateral. Therefore, for computational
purposes it is necessary to distinguish among the different possible
CE combinations that each loan or subset of loans in a Loan Group
may have. In the Stress Test, this is accomplished by creating
Distinct Credit Enhancement Combinations (DCCs).
1. Distinct Credit Enhancement Combinations. When aggregating
individual loans into Loan Groups for the RBC Report, the applicable
CE arrangements will have been identified for each loan:
a. Loan Group (LG) Number
b. Initial UPB of individual loan
c. Rating of MI or LSA Counterparty
d. Loan-Limit Coverage Percentage for MI or LSA
e. Contract Number for Aggregate Limit CE, First Priority
f. Contract Number for Aggregate Limit CE, Second Priority
g. Contract Number for Aggregate Limit CE, Third Priority
h. Contract Number for Aggregate Limit CE, Fourth Priority
2. Individual loans for which all of the entries in step 1) of this
section (except UPB and Loan-Limit Coverage Percent) are identical,
are aggregated into a DCCs. For example, all loans in a given Loan
Group with MI from a AAA-rated provider and no other CE would
comprise one DCC whose balance is the aggregate of the included
loans and whose MI Coverage Percent is the weighted average of that
of the included loans. In each month, within each Loan Group, for
each DCC, each applicable form of CE is applied in priority order to
reduce Gross Loss Severity as much as possible to zero. The total CE
payment for each DCC, as a percentage of Defaulted UPB is converted
to a total CE
[[Page 47847]]
payment for each Loan Group and then factored into the calculation
of Net Loss Severity in section 3.6.3.6.5, Single Family and
Multifamily Net Loss Severity, of this Appendix.
3. DCC First and Second Priority Available Aggregate CE Balance. In
the Stress Test, First and Second Priority Available Aggregate CE
Balances are allocated to the DCCs that are parties to each Contract
on a pro-rata basis. Third and Fourth Priority Aggregate Limit
Contracts are not modeled because they are extremely rare. In each
month of the Stress Test these CE Balances, adjusted by appropriate
Haircuts, are reduced by the losses incurred by each DCC that is a
party to each Contract. Spread Account deposits, if applicable, are
included in the First and Second Priority DCC Available Aggregate CE
Balances.
a. Spread Accounts may take one of two forms: Balance-Limited,
or Deposit-Limited. A Balance-Limited Spread Account receives
monthly spread payments based on the UPB of the covered loans until
a required balance is achieved and maintained. Any amounts paid to
cover losses must be replenished by future spread payments from the
covered loans that are still performing. Thus, there is no known
limit to the amount of spread deposits that may be made over the
life of the covered loans. In contrast, for a Deposit-Limited Spread
Account the limit is similar to a customary coverage limit. The
total amount of spread deposits made into the account is limited to
a maximum amount specified in the Contract.
b. In the Stress Test, the Available Contract Balance of a
Spread Account is adjusted prior to the calculation of the DCC
Available Balance as reported in the RBC Report. For each Spread
Account contract, the Enterprises report the Remaining Limit Amount,
which represents the maximum dollar amount of additional spread
deposits that could be required under the Contract. For Deposit-
Limited Spread Accounts, this amount is the maximum remaining dollar
amount of spread deposits required under the Contract. For Balance-
Limited Spread Accounts, this amount is defined as one-twelfth of
the annualized spread rate times the UPB of the covered loans at the
start of the Stress Test times the weighted average Remaining term
to Maturity of those loans. However, the maximum amount of spread
deposits that could be received will generally be higher than the
amount reasonably expected to be received during the Stress Test,
because the UPB of the covered loans, which is the basis for
determining the amounts of future spread deposits, declines over the
term of the Contract due to Amortization, Defaults, and Prepayments.
Therefore, the Enterprises report an adjusted Available Contract
Balance for both types of Spread Accounts before reporting the DCC
Available Balance by adding the lesser of the Remaining Limit Amount
or one-twelfth of the spread rate times the UPB of the covered loans
at the start of the stress test times 60 months.
c. Modified Pool Insurance, Limited Recourse, Limited
Indemnification and FHA risk-sharing contracts may have both loan-
level and aggregate-level coverage limits. To account for this
aspect of these types of Aggregate Limit CE, the Enterprises report
a DCC Loan Level Coverage Limit Amount, which represents the share
of each loss after deductibles (such as MI or First Priority
Contract payments) covered by a given MPI Contract. (The Loan Level
Coverage Limit Amount takes the value of one if the Contract is not
of this type, representing that 100 percent of losses are covered by
other types of Contracts).
d. In practice, Unlimited Recourse Contracts have neither loan-
level nor aggregate-level coverage limits. However, the Enterprises
report the Available Aggregate CE Balance of Unlimited Recourse
Contracts as the summation of the Original UPB of all covered loans.
e. The Available Aggregate CE Balances of Collateral Account
Contracts funded with anything other than Cash or Cash-equivalents
are discounted by thirty percent to account for market risk in
securities that are not cash equivalents.
f. Enterprise Loss Positions are treated as Aggregate Limit CE
in terms of reducing remaining losses eligible to be covered by a
next-priority Contract. However, since Enterprise Loss Positions are
typically a deductible for other forms of supplementary coverage,
payments from such accounts do not reduce loss severity.
[f] Multiple Layers of Credit Enhancement. For loans with more
than one type of Credit Enhancement, MI or Loss Sharing is applied
first, and then other types of CE (if available) are applied in
priority order to the remaining losses. MI and Loss Sharing claims
are payable regardless of whether (and to what extent) a loan is
also covered by other forms of CE. MI is unique in that the MI
payment is based on a percentage of a Claim Amount equal to the
entire Defaulted UPB plus expenses, not the actual loss incurred
upon liquidation. Therefore, an Enterprise can receive MI payments
on a defaulted loan in excess of the actual realized loss on that
loan. However, it is frequently the case that MI payments are
insufficient to cover the entire loss amount. In such cases, one or
more types of Aggregate Limit CE may be available to make up the
deficiency. Unlike MI claims, however, the Claim Amounts for Loss
Sharing and for all Aggregate Limit CE types do depend on the actual
losses incurred; and unlike Loss Sharing and MI, Claim Amounts
payable under other forms of CE are net of payments received on
account of other forms of CE. When a single loan is covered by
multiple forms of CE, the order in which they are to be applied
(First Priority, Second Priority, etc.) must be specified. To avoid
double-counting, a higher-numbered priority CE only covers losses
that were not covered by a lower-numbered priority CE.
3.6.3.6.4.2 Mortgage Credit Enhancement Inputs
[a] For each Loan Group, the inputs in Table 3-46 are required:
Table 3-46--CE Inputs for Each Loan Group
----------------------------------------------------------------------------------------------------------------
Variable Description Source
----------------------------------------------------------------------------------------------------------------
UPBORIGLG Origination UPB RBC Report
----------------------------------------------------------------------------------------------------------------
UPB0LG and UPBmLG Initial UPB and UPB in month m = section 3.6.3.3.4, Mortgage
0,1...120 Amortization Schedule Outputs
----------------------------------------------------------------------------------------------------------------
LTVORIGLG Original LTV RBC Report
----------------------------------------------------------------------------------------------------------------
DEFmLG and PERFmLG Defaulting and Performing Fractions of section 3.6.3.4.4, Single Family
Initial Loan Group UPB in month m = Default and Prepayment Outputs and
1...120 section 3.6.3.5.4, Multifamily Default
and Prepayment Outputs
----------------------------------------------------------------------------------------------------------------
CLMmMI,LG MI Claim Amount and LSA Claim Amount section 3.6.3.6.2, Single Family Gross
CLMmLSA,LG Loss Severity and section 3.6.3.6.3,
Multifamily Gross Loss Severity
----------------------------------------------------------------------------------------------------------------
GLSmLG Gross Loss Severity section 3.6.3.6.2, Single Family Gross
Loss Severity and section 3.6.3.6.3,
Multifamily Gross Loss Severity
----------------------------------------------------------------------------------------------------------------
[b] For each DCC covering loans in the Loan Group, the inputs in
Table 3-47 are required:
[[Page 47848]]
Table 3-47--Inputs for Each Distinct CE Combination (DCC)
----------------------------------------------------------------------------------------------------------------
Variable Description Source
----------------------------------------------------------------------------------------------------------------
PDCC Percent of Initial Loan Group UPB RBC Report
represented by individual loan(s) in a DCC
----------------------------------------------------------------------------------------------------------------
RMI,DCC or RLSA,DCC Credit rating of Loan Limit CE (MI or LSA) RBC Report
Counterparty
----------------------------------------------------------------------------------------------------------------
CMI,DCC or CLSA,DCC Weighted Average Coverage Percentage for MI RBC Report
or LSA Coverage (weighted by Initial UPB)
----------------------------------------------------------------------------------------------------------------
AB0DCC,C1 DCC Available First Priority CE Balance RBC Report
immediately prior to start of the Stress
Test
----------------------------------------------------------------------------------------------------------------
AB0DCC,C2 DCC Available Second Priority CE Balance RBC Report
immediately prior to start of the Stress
Test
----------------------------------------------------------------------------------------------------------------
RDCC,C1 DCC Credit Rating of First Priority CE RBC Report
Provider or Counterparty; or Cash/Cash
Equivalent (which is not Haircutted)
----------------------------------------------------------------------------------------------------------------
RDCC,C2 DCC Credit Rating of Second Priority CE RBC Report
Provider or Counterparty; or Cash/Cash
Equivalent (which is not Haircutted)
----------------------------------------------------------------------------------------------------------------
CDCC,C1 DCC Loan-Level Coverage Limit of First RBC Report
Priority Contract (If Subtype is MPI;
otherwise = 1)
----------------------------------------------------------------------------------------------------------------
CDCC,C2 DCC Loan-Limit Coverage Limit of Second RBC Report
Priority Contract (if Subtype is MPI;
otherwise = 1)
----------------------------------------------------------------------------------------------------------------
ExpMoDCC,C1 Month in the Stress Test (1...120 or after) RBC Report
in which the DCC First Priority Contract
expires
----------------------------------------------------------------------------------------------------------------
ExpMoDCC,C2 Month in the Stress Test (1...120 or after) RBC Report
in which the DCC Second Priority Contract
expires
----------------------------------------------------------------------------------------------------------------
ELPFDCC,C1 DCC Enterprise Loss Position Flag for First RBC Report
Priority Contract (Y or N)
----------------------------------------------------------------------------------------------------------------
ELPFDCC,C2 DCC Enterprise Loss Position Flag for RBC Report
Second Priority Contract (Y or N)
----------------------------------------------------------------------------------------------------------------
[c] In the RBC Report, Aggregate Limit CE Subtypes are grouped
as illustrated in Table 3-48.
Table 3-48--Aggregate Limit CE Subtype Grouping
------------------------------------------------------------------------
Symbol Subtype Also Includes
------------------------------------------------------------------------
REC Unlimited Recourse Unlimited
Indemnification
------------------------------------------------------------------------
PI Pool Insurance Pool Insurance
---------------------
Letter of Credit
---------------------
Subordination
Arrangements
------------------------------------------------------------------------
MPI Modified Pool Modified Pool
Insurance Insurance
---------------------
Limited Recourse
---------------------
Limited
Indemnification
---------------------
FHA Risk-sharing
Agreements
------------------------------------------------------------------------
CASH Cash Account Cash Account
------------------------------------------------------------------------
COLL Collateral Account Collateral
------------------------------------------------------------------------
ELP Enterprise Loss GSE Loss Position
Position (ledger item)
------------------------------------------------------------------------
SA Spread Account Spread Account
------------------------------------------------------------------------
3.6.3.6.4.3 Mortgage Credit Enhancement Procedures
[a] For each month m of the Stress Test, for each Loan Group
(LG), carry out the following six steps [a] 1-6 for each DCC.
Note: Process the Loan Groups and DCCs using the numerical order
assigned to them in the RBC Report.
1. Determine Mortgage Insurance Payment (MIm) for single
family loans in the DCC, or Loss Sharing Payment (LSAm)
for multifamily loans in the DCC, as a percentage of Defaulted UPB,
applying appropriate counterparty Haircuts from section 3.5, of this
Appendix:
[GRAPHIC] [TIFF OMITTED] TR13SE01.063
Where:
m' = min (m, 60). For counterparties rated below BBB, m' = 60
[[Page 47849]]
[GRAPHIC] [TIFF OMITTED] TR13SE01.065
2. Determine Remaining Loss in Dollars (RLD) after application of MI
or LSA and prior to application of other Aggregate Limit CE:
[GRAPHIC] [TIFF OMITTED] TR13SE01.066
3. Determine the contractual CE Payment in Dollars under the First
Priority Contract C1. Determine Payment after Haircut. Update
Remaining Loss Dollars and DCC Available Balance.
a. Determine CE Payment as the minimum of the Remaining Loss
Dollars after MI or LSA (if applicable) times the DCC Loan-Level
Coverage Limit (=1 if not MPI Contract) or the previous month's
ending DCC Available Balance:
[GRAPHIC] [TIFF OMITTED] TR13SE01.067
b. Determine CE Payment in Dollars after application of Haircuts:
[GRAPHIC] [TIFF OMITTED] TR13SE01.068
Where:
m' = min (m, 60). For counterparties rated below BBB, m' = 60.
c. Update DCC Remaining Loss Dollars and DCC Available Balance
under the First Priority Contract C1:
[GRAPHIC] [TIFF OMITTED] TR13SE01.069
Where:
ExpmC = 1 if the Contract has expired, i.e. if
the calendar month corresponding to the mth month of the
Stress Test is on or after the expiration month (ExpMoC)
ExpmC = 0 otherwise
4. Determine the contractual CE Payment in Dollars under the Second
Priority Contract C2. Determine Payment after Haircut. Update
Remaining Loss Dollars and DCC Available Balance.
a. Determine CE Payment as the minimum of the Remaining Loss
Dollars after C1 Payment (if applicable) times a DCC Loan-Level
Coverage Limit (=1 if not MPI Contract) or the previous month's
ending DCC Available Balance:
[GRAPHIC] [TIFF OMITTED] TR13SE01.070
b. Determine CE Payment in Dollars after application of Haircuts:
[GRAPHIC] [TIFF OMITTED] TR13SE01.071
Where:
m' = min (m, 60). For counterparties rated below BBB, m' = 60.
c. Update DCC Remaining Loss Dollars and DCC Available Balance
under the Second Priority Contract C2:
[GRAPHIC] [TIFF OMITTED] TR13SE01.072
Where:
ExpmC = 1 if the Contract has expired, i.e. if
the calendar month corresponding to the mth month of the
Stress Test is on or after the expiration month (ExpMoC)
ExpmC = 0 otherwise
5. Convert Aggregate Limit First and Second Priority Contract
receipts in Dollars for each DCC in month m to a percentage of DCC
Defaulted UPB:
[[Page 47850]]
[GRAPHIC] [TIFF OMITTED] TR13SE01.073
Where:
ELPI DCC,C1 = 0 if ELPFDCC,C1 = Y (Yes,
indicating that C1 is an Enterprise Loss Position)
ELPIDCC,C2 = 1 otherwise
6. Add the Loan Limit CE (MI and LSA) and Aggregate Limit CE (ALPD),
each expressed as a share of DCC Defaulted UPB, separately for each
DCC to increment the respective Loan Group totals:
[GRAPHIC] [TIFF OMITTED] TR13SE01.074
3.6.3.6.4.4 Mortgage Credit Enhancement Outputs
[a] Mortgage Credit Enhancement Outputs are set forth in Table
3-49.
Table 3-49--Single Family and Multifamily Credit Enhancement Outputs
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
MIm MI payments applied to reduce single
family Gross Loss Severity in month m
of the Stress Test (as a fraction of
Defaulted UPB in month m)
------------------------------------------------------------------------
LSAm LSA payments applied to reduce
multifamily Gross Loss Severity in
month m of the Street Test (as a
fraction of Defaulted UPB in month m)
------------------------------------------------------------------------
ALCEm Aggregate receipts from all forms of
Aggregate Limit Limit Credit
Enhancement applied to reduce single-
and multifamily Gross Loss Severity in
month m of the Stress Test (as a
fraction of Defaulted UPB in month m)
------------------------------------------------------------------------
[b] MImLG or LSAmLG
and ALCEmLG for months m = 1...120 of the
Stress Test are used in section 3.6.3.6.5, Single Family and
Multifamily Net Loss Severity, of this Appendix.
3.6.3.6.5 Single Family and Multifamily Net Loss Severity
3.6.3.6.5.1 Single Family and Multifamily Net Loss Severity
Procedures
Combine inputs and outputs from Gross Loss Severity and Credit
Enhancements (Table 3-42 through Table 3-49) in the following
formulas for each Loan Group in month m:
[a] For Conventional single family Loan Groups:
[GRAPHIC] [TIFF OMITTED] TR13SE01.075
[b] For Government single family Loan Groups, complete the
following three steps:
1. Compute a Loss Severity value for FHA-insured loans using the
Conventional formula for all government loans. FHA reimbursement
rates will be reflected in the value of MIm, as computed
in section 3.6.3.6.4.3, Mortgage Credit Enhancement Procedures, of
this Appendix.
2. Compute a Loss Severity value for VA-insured loans as follows for
all government loans:
[GRAPHIC] [TIFF OMITTED] TR13SE01.076
Where:
0.30 is a fixed percentage representing the VA guarantee coverage
percentage. (The VA coverage rate is a function of the initial loan
size.)
3. Compute Net Loss Severity by combining FHA-insured and VA-insured
Loss Severity values as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.077
[c] For multifamily Loan Groups other than FHA-Insured:
[[Page 47851]]
[GRAPHIC] [TIFF OMITTED] TR13SE01.078
[d] For FHA-Insured multifamily Loan Groups:
[GRAPHIC] [TIFF OMITTED] TR13SE01.079
3.6.3.6.5.2 Single Family and Multifamily Net Loss Severity Outputs
Net Loss Severity outputs are set forth in Table 3-50:
Table 3-50--Single Family and Multifamily Loss Severity Outputs
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
LSmSF Loss Severity (as a fraction of
Defaulted UPB) for single family loans
in month m
------------------------------------------------------------------------
LSmMF Loss Severity (as a fraction of
Defaulted UPB) for multifamily loans
in month m
------------------------------------------------------------------------
Single family and multifamily Loss Severities for months 1...120 of
the Stress Test are used in section 3.6.3.7, Stress Test Whole Loan
Cash Flows, of this Appendix.
3.6.3.7 Stress Test Whole Loan Cash Flows
3.6.3.7.1 Stress Test Whole Loan Cash Flow Overview
This section combines the mortgage Amortization Schedules with
Default, Prepayment and Net Loss Severity Rates to produce
performance-adjusted cash flows for Enterprise Whole Loans in the
Stress Test.
3.6.3.7.2 Stress Test Whole Loan Cash Flow Inputs
The inputs required to compute Stress Test Whole Loan Cash Flows
for each Loan Group are listed in Table 3-51.
Table 3-51--Inputs for Final Calculation of Stress Test Whole Loan Cash Flows
----------------------------------------------------------------------------------------------------------------
Variable Description Source
----------------------------------------------------------------------------------------------------------------
UPBm Aggregate Unpaid Principal Balance in month m section 3.6.3.3.4, Mortgage
= 0...RM Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
NYRm Net Yield Rate in month m = 1...RM section 3.6.3.3.4, Mortgage
Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
GF Guarantee Fee rate (weighted average for Loan RBC Report
Group) (decimal per annum)
----------------------------------------------------------------------------------------------------------------
PTRm Pass-Through Rate in month m = 1...RM section 3.6.3.3.4, Mortgage
Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
SPm Aggregate Scheduled Principal (Amortization) section 3.6.3.3.4, Mortgage
in month m = 1...RM Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
PREmSF Prepaying Fraction of original Loan Group in section 3.6.3.4.4, Single
PREmMF month m = 1...RM Family Default and
Prepayment Outputs and,
section 3.6.3.5.4,
Multifamily Default and
Prepayment Outputs
----------------------------------------------------------------------------------------------------------------
DEFmSF Defaulting Fraction of original Loan Group in section 3.6.3.4.4, Single
DEFmMF month m = 1...RM Family Default and
Prepayment Outputs and,
section 3.6.3.5.4,
Multifamily Default and
Prepayment Outputs
----------------------------------------------------------------------------------------------------------------
PERFmSF Performing Fraction of original Loan Group in section 3.6.3.4.4, Single
PERFmMF month m = 1...RM Family Default and
Prepayment Outputs and,
section 3.6.3.5.4,
Multifamily Default and
Prepayment Outputs
----------------------------------------------------------------------------------------------------------------
FDS Float Days for Scheduled Principal and RBC Report
Interest
----------------------------------------------------------------------------------------------------------------
FDP Float Days for Prepaid Principal RBC Report
----------------------------------------------------------------------------------------------------------------
FERm Float Earnings Rate in month m = 1...RM 1 week Fed Funds Rate;
section 3.3, Interest
Rates
----------------------------------------------------------------------------------------------------------------
LSmSF Loss Severity Rate in month m = 1...RM section 3.6.3.6.5.2, Single
Family and Multifamily Net
Loss Severity Outputs
----------------------------------------------------------------------------------------------------------------
FREP Fraction Repurchased (weighted average for RBC Report
Loan Group) (decimal)
----------------------------------------------------------------------------------------------------------------
[[Page 47852]]
3.6.3.7.3 Stress Test Whole Loan Cash Flow Procedures
[a] Calculate Stress Test whole loan cash flows using the
following nine steps:
1. Calculate Scheduled Principal Received (SPR) in month m:
[GRAPHIC] [TIFF OMITTED] TR13SE01.080
Note:
Scheduled Principal Received is zero, not negative, when
amortization is negative.
2. Calculate Net Interest Received (NIR) in month m. Any interest
shortfall due to Negative Amortization reduces Net Yield directly.
Note: NIR includes loans that default in month m, because lost
interest is included in Credit Losses in step 6) of this section.
(See section 3.6.3.6, Calculation of Single Family and Multifamily
Mortgage Losses, of this Appendix.)
[GRAPHIC] [TIFF OMITTED] TR13SE01.081
3. Calculate Prepaid Principal Received (PPR) in month m:
[GRAPHIC] [TIFF OMITTED] TR13SE01.082
4. Calculate newly Defaulted Principal (DP) in month m:
[GRAPHIC] [TIFF OMITTED] TR13SE01.083
5. Calculate Recovery Principal Received (RPR) on account of loans
that Defaulted in month m:
[GRAPHIC] [TIFF OMITTED] TR13SE01.084
6. Calculate Credit Losses (CL) on account of loans that Defaulted
in month m:
[GRAPHIC] [TIFF OMITTED] TR13SE01.085
In addition, if m = RM and UPBRM > 0 then,
[GRAPHIC] [TIFF OMITTED] TR13SE01.086
7. Calculate Performing Loan Group UPB in month m
(PUPBm), including PUPB0.
Note:
All loans are assumed to be performing in month 0; therefore
PUPB0 = UPB0.
[GRAPHIC] [TIFF OMITTED] TR13SE01.087
8. Calculate Total Principal Received (TPR) and Total Interest
Received (TIR) in month m:
[GRAPHIC] [TIFF OMITTED] TR13SE01.088
9. For Sold Loans, calculate the following cash flow components:
a. Guarantee Fee (GF) received in month m:
[GRAPHIC] [TIFF OMITTED] TR13SE01.089
b. Float Income (FI) received in month m:
[GRAPHIC] [TIFF OMITTED] TR13SE01.090
Where:
Prepayment Interest Shortfall (PIS) in month m is:
[GRAPHIC] [TIFF OMITTED] TR13SE01.091
[GRAPHIC] [TIFF OMITTED] TR13SE01.092
3.6.3.7.4 Stress Test Whole Loan Cash Flow Outputs
The Whole Loan Cash Flows in Table 3-52 are used to prepare pro
forma balance sheets and income statements for each month of the
Stress Period (see section 3.10 Operations, Taxes and Accounting, of
this Appendix). For Retained Loan groups, cash flows consist of
Scheduled Principal, Prepaid Principal, Defaulted Principal, Credit
Losses, and Interest. For Sold Loan groups, cash flow consists of
Credit Losses, Guarantee Fees and Float Income. For Repurchased
MBSs, cash flows are allocated according to the Fraction
Repurchased. Table 3-52 covers all cases; for Retained Loans FREP =
1.0.
Table 3-52--Outputs for Whole Loan Cash Flows
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
SPRm Scheduled Principal Received in month
m = 1...RM
------------------------------------------------------------------------
PPRm Prepaid Principal Received in month m =
1...RM
------------------------------------------------------------------------
DPm Defaulted Principal in month m = 1...RM
------------------------------------------------------------------------
CLm Credit Losses in month m = 1...RM
------------------------------------------------------------------------
PUPBm Performing Loan Group UPB in month m =
0...RM
------------------------------------------------------------------------
TPRm Total Principal Received in month m =
1...RM
------------------------------------------------------------------------
TIRm Total Interest Received in month m =
1...RM
------------------------------------------------------------------------
GFm Guarantee Fees received in month m =
1...RM
------------------------------------------------------------------------
FIm Float Income received in month m =
1...RM
------------------------------------------------------------------------
Table 3-53--Additional Outputs for Repurchased MBSs
----------------------------------------------------------------------------------------------------------------
Variable Quantity Description
----------------------------------------------------------------------------------------------------------------
STPRm FREP x (SPRm + PPRm+ DPm) Enterprise's portion of Total Principal
Received in months m = 1...RM, reflecting
its fractional ownership of the MBS
----------------------------------------------------------------------------------------------------------------
STIRm FREP x (TIRm-GFm) Enterprise's portion of Total Interest
Received (at the Pass-Through Rate) in
months m = 1...RM, reflecting its
fractional ownership of the MBS
----------------------------------------------------------------------------------------------------------------
[[Page 47853]]
SPUPBm FREP x PUPBm Enterprise's portion of the Performing UPB
of the repurchased MBS in months m =
0...RM, reflecting its fractional ownership
of the MBS
----------------------------------------------------------------------------------------------------------------
3.6.3.8 Whole Loan Accounting Flows
3.6.3.8.1 Whole Loan Accounting Flows Overview
[a] For accounting purposes, cash flows are adjusted to reflect
(1) the value over time of discounts, premiums and fees paid or
received (Deferred Balances) when an asset was acquired; and (2) the
fact that mortgage interest is paid in arrears, i.e. it is received
in the month after it is earned. In the Stress Test calculations,
payments are indexed by the month in which they are received.
Therefore, interest received in month m was earned in month m-1.
However, principal is accounted for in the month received.
[b] Deferred Balances are amortized over the remaining life of
the asset. Therefore, these calculations go beyond the end of the
Stress Test if the Remaining Maturity (RM) is greater than the 120
months of the Stress Test. The projection of cash flows beyond the
end of the Stress Test is discussed in the individual sections where
the cash flows are first calculated. In general, for interest rate
indexes, monthly Prepayment rates and monthly Default rates, the
value for m = 120 is used for all months 120 m RM, but
LS = 0 for m > 120.
3.6.3.8.2 Whole Loan Accounting Flows Inputs
The inputs in Table 3-54 are required to compute Accounting
Flows:
Table 3-54--Inputs for Whole Loan Accounting Flows
----------------------------------------------------------------------------------------------------------------
Variable Description Source
----------------------------------------------------------------------------------------------------------------
RM Remaining Term to Maturity in months RBC Report
----------------------------------------------------------------------------------------------------------------
UPD0 Unamortized Premium (positive) or Discount RBC Report
(negative) (Deferred Balances) for the Loan
Group at the start of the Stress Test
----------------------------------------------------------------------------------------------------------------
NYR0 Net Yield Rate at time zero section 3.6.3.3.4, Mortgage
Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
PUPBm Performing Loan Group UPB in months m = section 3.6.3.7.4, Stress
0...RM Test Whole Loan Cash Flow
Outputs
----------------------------------------------------------------------------------------------------------------
PTR0 Pass-Through Rate at time zero section 3.6.3.3.4, Mortgage
Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
SPUPBm Security Performing UPB in months m = 0...RM section 3.6.3.7.4, Stress
Test Whole Loan Cash Flow
Outputs
----------------------------------------------------------------------------------------------------------------
SUPD0 Security Unamortized Premium (positive) or RBC Report
Discount (negative) associated with the
repurchase price of a Repurchased MBS
(aggregate over all purchases of the same
MBS)
----------------------------------------------------------------------------------------------------------------
3.6.3.8.3 Whole Loan Accounting Flows Procedures
3.6.3.8.3.1 Accounting for Retained and Sold Whole Loans
[a] Complete the following three steps to account for Retained
and Sold loans:
1. Compute Allocated Interest in month m (AI\m\) as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.093
Note:
Allocated Interest is used only to determine the allocation of
Amortization Expense over time, not to generate actual cash flows)
2. Calculate the monthly Internal Rate of Return (IRR) that equates
the adjusted cash flows (actual principal plus Allocated Interest)
to the Initial Book Value (BV0) of the Loan Group. A
single IRR is used for all months m. Solve for IRR such that:
[GRAPHIC] [TIFF OMITTED] TR13SE01.094
Where:
[GRAPHIC] [TIFF OMITTED] TR13SE01.095
3. Calculate the monthly Amortization Expense for each month m:
a. If BV0 0, or if 12 x IRR > 1.0 (100%), or if
[GRAPHIC] [TIFF OMITTED] TR13SE01.096
then the full amount of UPD0 is realized in the first
month (AE1 = -UPD0)
b. Otherwise:
[GRAPHIC] [TIFF OMITTED] TR13SE01.097
3.6.3.8.3.2 Additional Accounting for Repurchased MBSs
[a] Complete the following three steps to account for
Repurchased MBSs:
1. Compute Security Allocated Interest in month m (SAIm)
as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.098
Note: Security Allocated Interest is used only to determine the
allocation of Security Amortization Expense over time, not to
generate actual cash flows.
2. Calculate the monthly Internal Rate of Return (IRR) that equates
the adjusted cash flows (actual principal plus Allocated Interest)
to the Initial Book Value (SBV0) of the Loan Group. A
single IRR is used for all months m. Solve for IRR such that:
[GRAPHIC] [TIFF OMITTED] TR13SE01.099
Where:
SBV0 = SPUPB0 + SUPD0
SACFm = SAIm - SPUPBm +
SPUPBm-1
3. Calculate the monthly Security Amortization Expense for each
month m:
a. If SBV0 0, or if 12 x IRR > 1.0 (100%), or if
[GRAPHIC] [TIFF OMITTED] TR13SE01.100
then the full amount of SUPD0 is realized in the first
month (SAE1 = -SUPD0).
[[Page 47854]]
b. Otherwise:
[GRAPHIC] [TIFF OMITTED] TR13SE01.101
3.6.3.8.4 Whole Loan Accounting Flows Outputs
Whole loan accounting flows outputs are set forth in Table 3-55.
Amortization Expense for months m = 1...RM are used in section 3.10,
Operations, Taxes, and Accounting, of this Appendix.
Table 3-55--Outputs for Whole Loan Accounting Flows
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
AEm Amortization Expense for months
m = 1...RM
------------------------------------------------------------------------
SAEm Security Amortization Expense
for months m = 1...RM
------------------------------------------------------------------------
3.6.4 Final Whole Loan Cash Flow Outputs
The final outputs for section 3.6, Whole Loan Cash Flows, of
this Appendix are as specified in Table 3-52, and Table 3-55.
3.7 Mortgage-Related Securities Cash Flows
3.7.1 Mortgage-Related Securities Overview
[a] Mortgage-Related Securities (MRSs) include Single Class
MBSs, Multi-class MBSs (REMICs or Collateralized Mortgage
Obligations (CMOs)), Mortgage Revenue Bonds (MRBs), and Derivative
Mortgage Securities such as Interest-Only and Principal-Only
Stripped MBSs. MBSs and Derivative Mortgage Securities are issued by
the Enterprises, Ginnie Mae and private issuers. MRBs are issued by
State and local governments or their instrumentalities. For
computational purposes, certain Asset-Backed Securities (ABS) backed
by mortgages (Mortgage ABSs backed by manufactured housing loans,
second mortgages or home equity loans) are treated as REMICs in the
Stress Test.
[b] Cash flows from Single Class MBSs represent the pass-through
of all principal and interest payments, net of servicing and
guarantee fees, on the underlying pools of mortgages. Cash flows
from Multi-Class MBSs and Derivative Mortgage Securities represent a
specified portion of the cash flows produced by an underlying pool
of mortgages and/or Mortgage-Related Securities, determined
according to rules set forth in offering documents for the
securities. MRBs may have specific maturity schedules and call
provisions, whereas MBSs have only expected maturities and, in most
cases, no issuer call provision (other than ``cleanup calls'' if the
pool balance becomes quite small). However, the timing of principal
payments for MRBs is still closely related to that of their
underlying mortgage collateral. The Stress Test treats most MRBs in
a manner similar to single class MBSs. Finally, a small number of
Enterprise and private label REMIC securities for which modeling
information is not readily available and which are not modeled by a
commercial information service (referred to as ``miscellaneous
MRS'') are treated separately.
[c] In addition to reflecting the defaults of mortgage borrowers
during the Stress Period, the Stress Test considers the possibility
of issuer Default on Mortgage-Related Securities. Credit impairments
throughout the Stress Period are based on the rating of these
securities, and are modeled by reducing contractual interest
payments and ``writing down'' principal. No Credit Losses are
assumed for the Enterprise's own securities and Ginnie Mae
securities (see section 3.5.3, Counterparty Defaults Procedures, of
this Appendix).
[d] The calculation of cash flows for Mortgage-Related
Securities requires information from the Enterprises identifying
their holdings, publicly available information characterizing the
securities, and information on the interest rate, mortgage
performance and credit rating (for rated securities).
[e] Cash and accounting flows--monthly principal and interest
payments and amortization expense--are produced for each month of
the Stress Period for each security. (Principal- and interest-only
securities pay principal or interest respectively.) These cash flows
are input to the Operations, Taxes, and Accounting component of the
Stress Test.
3.7.2 Mortgage-Related Securities Inputs
3.7.2.1 Inputs Specifying Individual Securities
3.7.2.1.1 Single Class MBSs
The information in Table 3-56 is required for single class MBSs
held by an Enterprise at the start of the Stress Test. This
information identifies the Enterprise's holdings and describes the
MBS and the underlying mortgage loans.
Table 3-56--RBC Report Inputs for Single Class MBS Cash Flows
----------------------------------------------------------------------------------------------------------------
Variable Description
----------------------------------------------------------------------------------------------------------------
Pool Number A unique number identifying each mortgage pool
----------------------------------------------------------------------------------------------------------------
CUSIP Number A unique number assigned to publicly traded securities by the
Committee on Uniform Securities Identification Procedures
----------------------------------------------------------------------------------------------------------------
Issuer Issuer of the mortgage pool
----------------------------------------------------------------------------------------------------------------
Original UPB Amount Original pool balance multiplied by the Enterprise's percentage
ownership.
----------------------------------------------------------------------------------------------------------------
Current UPB Amount Initial Pool balance (at the start of the Stress Test), multiplied
by the Enterprise's percentage ownership
----------------------------------------------------------------------------------------------------------------
Product Code Mortgage product type for the pool
----------------------------------------------------------------------------------------------------------------
Security Rate Index If the rate on the security adjusts over time, the index that the
adjustment is based on
----------------------------------------------------------------------------------------------------------------
Unamortized Balance The sum of all unamortized discounts, premiums, fees, commissions,
etc. Components of the balance that amortize as a gain (like
discounts) should be positive. Components that amortize as a cost
or as a loss (premiums, fees, etc.) should be negative.
----------------------------------------------------------------------------------------------------------------
Wt Avg Original Amortization Term Original amortization term of the underlying loans, in months
(weighted average for underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Remaining Term of Maturity Remaining Maturity of the underlying loans at the start of the
Stress Test (weighted average for underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Age Age of the underlying loans at the start of the Stress Test
(weighted average for underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Current Mortgage Interest rate Mortgage Interest Rate of the underlying loans at the start of the
Stress Test (weighted average for underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Pass-Through Rate Pass-Through Rate of the underlying loans at the start of the
Stress Test (weighted average for underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Original Mortgage Interest Rate The current UPB weighted average Mortgage Interest Rate in effect
at Origination for the loans in the pool
----------------------------------------------------------------------------------------------------------------
[[Page 47855]]
Security Rating The most current rating issued by any Nationally Recognized
Statistical Rating Organization (NRSRO) for this security, as of
the reporting date. In the case of a ``split'' rating, the lowest
rating should be given.
----------------------------------------------------------------------------------------------------------------
Wt Avg Gross Margin Gross margin for the underlying loans (ARM MBS only) (weighted
average for underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Net Margin Net margin (used to determine the security rate for ARM MBS)
(weighted average for underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Rate Reset Period Rate reset period in months (ARM MBS only) (weighted average for
underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Rate Reset Limit Rate reset limit up/down (ARM MBS only) (weighted average for
underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Life Interest Rate Ceiling Maximum rate (lifetime cap) (ARM MBS only) (weighted average for
underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Life Interest Rate Floor Minimum rate (lifetime floor) (ARM MBS only) (weighted average for
underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Payment Reset Period Payment reset period in months (ARM MBS only) (weighted average for
underlying loans).
----------------------------------------------------------------------------------------------------------------
Wt Avg Payment Reset Limit Payment reset limit up/down (ARM MBS only) (weighted average for
underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Lookback Period The number of months to look back from the interest rate change
date to find the index value that will be used to determine the
next interest rate (ARM MBS only) (weighted average for underlying
loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Negative Amortization Cap The maximum amount to which the balance can increase before the
payment is recast to a fully amortizing amount. It is expressed as
a fraction of the original UPB. (ARM MBS only) (weighted average
for underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Initial Interest Rate Period Number of months between the loan origination date and the first
rate adjustment date (ARM MBS only) (weighted average for
underlying loans)
----------------------------------------------------------------------------------------------------------------
Wt Avg Unlimited Payment Reset Period Number of months between unlimited payment resets i.e., not limited
by payment caps, starting with Origination date (ARM MBS only)
(weighted average for underlying loans)
----------------------------------------------------------------------------------------------------------------
Notional Flag Indicates that amounts reported in Original UPB Amount and Current
UPB Amount are notional
----------------------------------------------------------------------------------------------------------------
UPB Scale Factor Factor applied to the current UPB that offsets any timing
adjustments between the security level data and the Enterprise's
published financials
----------------------------------------------------------------------------------------------------------------
Whole Loan Modeling Flag Indicates that the Current UPB Amount and Unamortized Balance
associated with this Repurchased MBS are included in the Wt Avg
Percent Repurchased and Security Unamortized Balance fields
----------------------------------------------------------------------------------------------------------------
FAS 115 Classification The financial instrument's classification according to FAS 115
----------------------------------------------------------------------------------------------------------------
HPGRK Vector of House Price Growth Rates for quarters q=1...40 of the
Stress Period.
----------------------------------------------------------------------------------------------------------------
3.7.2.1.2 Multi-Class MBSs and Derivative Mortgage Securities
[a] The information in Table 3-57 is required for Multi-Class
MBSs and Derivative Mortgage Securities held by an Enterprise at the
start of the Stress Test. This information identifies the MBS and an
Enterprise's holdings.
Table 3-57--RBC Report Inputs for Multi-Class and Derivative MBS Cash Flows
----------------------------------------------------------------------------------------------------------------
Variable Description
----------------------------------------------------------------------------------------------------------------
CUSIP Number A unique number assigned to publicly traded securities by the
Committee on Uniform Securities Identification Procedures
----------------------------------------------------------------------------------------------------------------
Issuer Issuer of the security: FNMA, FHLMC, GNMA or other
----------------------------------------------------------------------------------------------------------------
Original Security Balance Original principal balance of the security (notional amount for
Interest-Only securities) at the time of issuance, multiplied by
the Enterprise's percentage ownership
----------------------------------------------------------------------------------------------------------------
Current Security Balance Initial principal balance, or notional amount, at the start of the
Stress Period multiplied by the Enterprise's percentage ownership
----------------------------------------------------------------------------------------------------------------
Current Security Percentage Owned The percentage of a security's total current balance owned by the
Enterprise
----------------------------------------------------------------------------------------------------------------
Unamortized Balance The sum of all unamortized discounts, premiums, fees, commissions,
etc. Components of the balance that amortize as a gain (like
discounts) should be positive. Components that amortize as a cost
or as a loss (premiums, fees, etc.) should be negative.
----------------------------------------------------------------------------------------------------------------
[b] The Stress Test requires sufficient information about the
cash flow allocation rules among the different classes of a Multi-
Class MBS to determine the cash flows for the individual class(es)
owned by an Enterprise, including descriptions of the component
classes of the security, the underlying collateral, and the rules
directing cash flows to the component classes. This information is
obtained from offering documents or securities data services. In the
Stress Test, this information is used either as an input to a
commercial modeling service or, for securities that are not so
modeled, to derive an approximate modeling treatment as described
more fully in this section.
[c] If a Derivative Mortgage Security is itself backed by one or
more underlying
[[Page 47856]]
securities, sufficient information is required for each underlying
security as described in the preceding paragraph.
3.7.2.1.3 Mortgage Revenue Bonds and Miscellaneous MRSs
[a] The Stress Test requires two types of information for
Mortgage Revenue Bonds and miscellaneous MRS held by an Enterprise
at the start of the Stress Test: information identifying the
Enterprise's holdings and the contractual terms of the securities.
The inputs required for these instruments are set forth in Table 3-
58.
Table 3-58--RBC Report Inputs for MRBs and Derivative MBS Cash Flows
----------------------------------------------------------------------------------------------------------------
Variable Description
----------------------------------------------------------------------------------------------------------------
CUSIP Number A unique number assigned to publicly traded securities by the
Committee on Uniform Securities Identification Procedures
----------------------------------------------------------------------------------------------------------------
Original Security Balance Original principal balance, multiplied by the Enterprise's
percentage ownership
----------------------------------------------------------------------------------------------------------------
Current Security Balance Initial principal balance (at start of Stress Period), multiplied
by the Enterprise's percentage ownership
----------------------------------------------------------------------------------------------------------------
Unamortized Balance The sum of all unamortized discounts, premiums, fees, commissions,
etc. Components of the balance that amortize as a gain (like
discounts) should be positive. Components that amortize as a cost
or as a loss (premiums, fees, etc.) should be negative.
----------------------------------------------------------------------------------------------------------------
Issue Date The Issue Date of the security
----------------------------------------------------------------------------------------------------------------
Maturity Date The stated Maturity Date of the security
----------------------------------------------------------------------------------------------------------------
Security Interest Rate The rate at which the security earns interest, as of the reporting
date
----------------------------------------------------------------------------------------------------------------
Principal Payment Window Starting Date, The month in the Stress Test that principal payment is expected to
Down-Rate Scenario start for the security under the statutory ``down'' interest rate
scenario, according to Enterprise projections
----------------------------------------------------------------------------------------------------------------
Principal Payment Window Ending Date, Down- The month in the Stress Test that principal payment is expected to
Rate Scenario end for the security under the statutory ``down'' interest rate
scenario, according to Enterprise projections
----------------------------------------------------------------------------------------------------------------
Principal Payment Window Starting Date, Up- The month in the Stress Test that principal payment is expected to
Rate Scenario start for the security under the statutory ``up'' interest rate
scenario, according to Enterprise projections
----------------------------------------------------------------------------------------------------------------
Principal Payment Window Ending Date, Up- The month in the Stress Test that principal payment is expected to
Rate Scenario end for the security under the statutory ``up'' interest rate
scenario, according to Enterprise projections
----------------------------------------------------------------------------------------------------------------
Security Rating The most current rating issued by any Nationally Recognized
Statistical Rating Organization (NRSRO) for this security, as of
the reporting date. In the case of a ``split'' rating, the lowest
rating should be given.
----------------------------------------------------------------------------------------------------------------
Security Rate Index If the rate on the security adjusts over time, the index on which
the adjustment is based
----------------------------------------------------------------------------------------------------------------
Security Rate Index Coefficient If the rate on the security adjusts over time, the coefficient is
the number used to multiply by the value of the index
----------------------------------------------------------------------------------------------------------------
Security Rate Index Spread If the rate on the security adjusts over time, the spread is added
to the value of the index multiplied by the coefficient to
determine the new rate
----------------------------------------------------------------------------------------------------------------
Security Rate Adjustment Frequency The number of months between rate adjustments
----------------------------------------------------------------------------------------------------------------
Security Interest Rate Ceiling The maximum rate (lifetime cap) on the security
----------------------------------------------------------------------------------------------------------------
Security Interest Rate Floor The minimum rate (lifetime floor) on the security
----------------------------------------------------------------------------------------------------------------
[b] The Payment Window Starting and Ending Dates are projected
by the Enterprise on the basis of prospectus information or
simulations from a dealer in the securities or other qualified
source, such as the structured finance division of an accounting
firm, for the two statutory scenarios.
3.7.2.2 Interest Rate Inputs
Interest rates projected for each month of the Stress Period are
used to calculate principal amortization and interest payments for
ARM MBSs and MRBs, and for Derivative Mortgage Securities with
indexed coupon rates. This information is produced in section 3.3,
Interest Rates, of this Appendix.
3.7.2.3 Mortgage Performance Inputs
Default and Prepayment rates for the loans underlying a single-
or multiclass MBS are computed according to the characteristics of
the loans as specified in this section 3.7.2, Mortgage-Related
Securities Inputs. LTV and Census Region are not uniquely specified
for the loans underlying a given security; instead, the Prepayment
and Default rates are averaged over all LTV categories, weighted
according to the distribution of LTVs given in Table 3-59. (This
weighting applies to Time Zero, i.e., the start of the Stress Test;
the weightings will change over time as individual LTV groups pay
down at different rates. See section 3.7.3, Mortgage-Related
Securities Procedures, of this Appendix.) Instead of Census
Division, the national average HPI is used for all calculations in
this section.
Table 3-59--Aggregate Enterprise Amortized Original LTV (AOLTV0)
Distribution \1\
------------------------------------------------------------------------
Wt Avg
Original LTV UPB AOLTV for
Distribution Range
------------------------------------------------------------------------
00LTV=60 17.00% 48.35%
------------------------------------------------------------------------
60LTV=70 14.15% 66.35%
------------------------------------------------------------------------
70LTV=75 14.99% 73.81%
------------------------------------------------------------------------
75LTV=80 26.84% 79.30%
------------------------------------------------------------------------
80LTV=90 14.78% 88.31%
------------------------------------------------------------------------
90LTV=95 10.89% 94.67%
------------------------------------------------------------------------
95LTV=100 1.35% 97.51%
------------------------------------------------------------------------
100LTV 0.00% 100.02%
------------------------------------------------------------------------
\1\ Source: Combined Enterprise Portfolios as of the second quarter,
2000.
[[Page 47857]]
Note: Amortized Original LTV (also known as the ``current-loan-to-
original-value'' ratio) is the Original LTV adjusted for the change in
UPB but not for changes in property value. Because of its small size
the LTV>100 group is not used in the calculation.
3.7.2.4 Third-Party Credit Inputs
For securities not issued by the Enterprise or Ginnie Mae,
issuer Default risk is reflected by haircutting the instrument cash
flows based on the rating of the security, as described in section
3.5, Counterparty Defaults, of this Appendix.
3.7.3 Mortgage-Related Securities Procedures
The following sections describe the calculations for (1) single
class MBSs, (2) Multi-Class MBSs and derivative mortgage securities,
and (3) MRBs and miscellaneous MRS.
3.7.3.1 Single Class MBSs
[a] The calculation of cash flows for single class MBSs is based
on the procedures outlined earlier in section 3.6, Whole Loan Cash
Flows, of this Appendix. The collateral (i.e., the mortgage pool)
underlying each MBS is treated as one single family Loan Group with
characteristics equal to the weighted average characteristics of the
underlying loans.
[b] For each MBS, compute the scheduled cash flows specified in
Table 3-33, as directed in section 3.6.3.3.3, Mortgage Amortization
Schedule Procedures of this Appendix, with the following exceptions
and clarifications:
1. The Net Yield Rate (NYR) is not used in the MBS calculation.
Instead, the Pass-Through Rate (for Fixed-Rate MBSs) and INDEX + Net
Margin (for Adjustable-Rate MBSs) are used.
2. PMT is not a direct input for MBSs. (That is, it is not specified
in the RBC Report.) Instead, compute PMT from UPB, MIR and remaining
amortizing term AT-A0, using the standard mortgage
payment formula (and update it as appropriate for ARMs, as described
in the Whole Loan calculation).
3. For ARM MBS, interest rate and monthly payment adjustments for
the underlying loans are calculated in the same manner as they are
for ARM Loan Groups.
4. MBSs backed by Biweekly mortgages, GPMs, TPMs, GEMs, and Step
mortgages are mapped into mortgage types as described in section
3.6, Whole Loan Cash Flows, of this Appendix.
[c] Use the Loan Group characteristics to generate Default and
Prepayment rates as described in section 3.6.3.4.3, Single Family
Default and Prepayment Procedures, of this Appendix. For the
following explanatory variables that are not specified for MBSs,
proceed as follows:
1. For fixed rate Ginnie Mae certificates and the small number of
multifamily MBS held by the Enterprises, use the model coefficients
for Government Loans. For loans underlying Ginnie Mae ARM
certificates, use the conventional ARM model coefficients.
2. Set Investor Fraction (IF) = 7.56%
3. Set Relative Loan Size (RLS) = 1.0. For Ginnie Mae certificates,
use RLS = 0.75.
4. For LTVORIG of the underlying loans: Divide the MBS's
single weighted average Loan Group into several otherwise identical
Loan Groups (``LTV subgroups''), one for each Original LTV range
specified in Table 3-59. UPB0 for each of these LTV
subgroups is the specified percentage of the aggregate
UPB0. AOLTV0 for each subgroup is also
specified in Table 3-59. For Ginnie Mae certificates, use only the
95 LTV 100 LTV category and its associated weighted
average LTV.
5. For each LTV subgroup, compute LTV0 as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.102
Where:
HPI = the national average HPI figures in Table 3-60 (updated as
necessary from subsequent releases of the OFHEO HPI).
A0 = weighted average age in months of the underlying
loans immediately prior to the start of the Stress Test.
AQ0 = weighted average age in quarters of the underlying
loans immediately prior to the start of the Stress Test.
AQ0 = int (A0/3).
AQ'0 = AQ0 minus the number of whole quarters
between the most recently available HPI at the start of the Stress
Test and time zero.
If AQ'00, then LTV0 =
AOLTV0.
Table 3-60--Historical National Average HPI \1\
----------------------------------------------------------------------------------------------------------------
Quarter \2\ HPI Quarter HPI Quarter HPI
----------------------------------------------------------------------------------------------------------------
1975Q1 62.45 1983Q4 116.63 1992Q3 177.94
----------------------------------------------------------------------------------------------------------------
1975Q2 63.50 1984Q1 118.31 1992Q4 178.71
----------------------------------------------------------------------------------------------------------------
1975Q3 62.85 1984Q2 120.40 1993Q1 178.48
----------------------------------------------------------------------------------------------------------------
1975Q4 63.92 1984Q3 121.68 1993Q2 179.89
----------------------------------------------------------------------------------------------------------------
1976Q1 65.45 1984Q4 122.94 1993Q3 180.98
----------------------------------------------------------------------------------------------------------------
1976Q2 66.73 1985Q1 124.81 1993Q4 182.38
----------------------------------------------------------------------------------------------------------------
1976Q3 67.73 1985Q2 126.91 1994Q1 183.35
----------------------------------------------------------------------------------------------------------------
1976Q4 68.75 1985Q3 129.38 1994Q2 183.95
----------------------------------------------------------------------------------------------------------------
1977Q1 70.70 1985Q4 131.20 1994Q3 184.43
----------------------------------------------------------------------------------------------------------------
1977Q2 73.34 1986Q1 133.77 1994Q4 184.08
----------------------------------------------------------------------------------------------------------------
1977Q3 75.35 1986Q2 136.72 1995Q1 184.85
----------------------------------------------------------------------------------------------------------------
1977Q4 77.71 1986Q3 139.37 1995Q2 187.98
----------------------------------------------------------------------------------------------------------------
1978Q1 79.96 1986Q4 141.99 1995Q3 190.81
----------------------------------------------------------------------------------------------------------------
1978Q2 82.75 1987Q1 145.07 1995Q4 192.42
----------------------------------------------------------------------------------------------------------------
1978Q3 85.39 1987Q2 147.88 1996Q1 194.80
----------------------------------------------------------------------------------------------------------------
1978Q4 87.88 1987Q3 150.21 1996Q2 195.00
----------------------------------------------------------------------------------------------------------------
1979Q1 91.65 1987Q4 151.57 1996Q3 195.78
----------------------------------------------------------------------------------------------------------------
1979Q2 94.26 1988Q1 154.26 1996Q4 197.48
----------------------------------------------------------------------------------------------------------------
1979Q3 96.24 1988Q2 157.60 1997Q1 199.39
----------------------------------------------------------------------------------------------------------------
[[Page 47858]]
1979Q4 98.20 1988Q3 159.25 1997Q2 201.00
----------------------------------------------------------------------------------------------------------------
1980Q1 100.00 1988Q4 160.96 1997Q3 203.94
----------------------------------------------------------------------------------------------------------------
1980Q2 100.86 1989Q1 163.10 1997Q4 206.97
----------------------------------------------------------------------------------------------------------------
1980Q3 104.27 1989Q2 165.33 1998Q1 210.09
----------------------------------------------------------------------------------------------------------------
1980Q4 104.90 1989Q3 169.09 1998Q2 212.37
----------------------------------------------------------------------------------------------------------------
1981Q1 105.69 1989Q4 170.74 1998Q3 215.53
----------------------------------------------------------------------------------------------------------------
1981Q2 107.85 1990Q1 171.42 1998Q4 218.09
----------------------------------------------------------------------------------------------------------------
1981Q3 109.21 1990Q2 171.31 1999Q1 220.80
----------------------------------------------------------------------------------------------------------------
1981Q4 109.38 1990Q3 171.85 1999Q2 224.32
----------------------------------------------------------------------------------------------------------------
1982Q1 111.02 1990Q4 171.03 1999Q3 228.46
----------------------------------------------------------------------------------------------------------------
1982Q2 111.45 1991Q1 172.41 1999Q4 232.41
----------------------------------------------------------------------------------------------------------------
1982Q3 110.91 1991Q2 173.14 2000Q1 235.91
----------------------------------------------------------------------------------------------------------------
1982Q4 111.96 1991Q3 173.14 2000Q2 240.81
----------------------------------------------------------------------------------------------------------------
1983Q1 114.12 1991Q4 175.46 2000Q3 245.15
----------------------------------------------------------------------------------------------------------------
1983Q2 115.33 1992Q1 176.62
----------------------------------------------------------------------------------------------------------------
1983Q3 116.15 1992Q2 176.26
----------------------------------------------------------------------------------------------------------------
\1\ These numbers are updated as necessary from subsequent releases of the HPI after 2000Q3.
\2\ Note: If the underlying loans were originated before 1975, use the HPI from 1975Q1 as HPIORIG.
6. For each quarter q of the Stress Test, use UPBq and
the house price growth rates from the Benchmark regional time
period:
[GRAPHIC] [TIFF OMITTED] TR13SE01.103
7. Generate Default, Prepayment and Performance vectors
PREm, DEFm and PERFm for each LTV
subgroup. When LTVORIG is used as a categorical variable,
use the corresponding range defined for each LTV subgroup in Table
3-59. For LTV subgroup 95 LTV 100, use 90 LTVORIG in
Table 3-35.
[d] For each LTV subgroup, do not compute any Loss Severity or
Credit Enhancement amounts. MBS investors receive the full UPB of
defaulted loans.
[e] Compute Total Principal Received (TPR), Total Interest
Received (TIR), and Amortization Expense (AE) for each LTV subgroup
as directed in section 3.6.3.7.3, Stress Test Whole Loan Cash Flow
Procedures and section 3.6.3.8.3, Whole Loan Accounting Flows
Procedures, of this Appendix, with the following exception:
1. For Net Interest Received (NIR), do not use the Net Yield Rate
(NYRm). Instead, use the Pass-Through Rate
(PTRm) for Fixed Rate Loans, and INDEXm-1-LB +
Wt Avg Net Margin, subject to rate resets as described in section
3.6.3.3.3, Mortgage Amortization Schedule Procedures, [a]1.b.3) of
this Appendix, for ARMs.
2. Calculate Recovery Principal Received using a Loss Severity
rate of zero (LS = 0).
[f] Sum over the LTV subgroups to obtain the original MBS's TPR,
TIR and AE for m = 1...RM.
[g] Apply counterparty Haircuts in each month m as follows:
1. Compute:
[GRAPHIC] [TIFF OMITTED] TR13SE01.104
Where:
m' = min (m, 60)
R = MBS credit rating
2. Compute:
[GRAPHIC] [TIFF OMITTED] TR13SE01.105
[h] The resulting values, for each MBS, of TPR, TIR, AE, and
HctAmt for months m = 1...RM are used in the section 3.10,
Operations, Taxes, and Accounting, of this Appendix.
3.7.3.2 REMICs and Strips
[a] Cash flows for REMICs and Strips are generated according to
standard securities industry procedures, as follows:
1. From the CUSIP number of the security, identify the
characteristics of the underlying collateral. This is facilitated by
using a securities data service.
2. Calculate the cash flows for the underlying collateral in the
manner described for whole loans and MBS, based on Stress Test
interest, Default, and Prepayment rates appropriate for the
collateral.
3. Calculate cash flows for the Multiclass MBS using the allocation
rules specified in the offering materials.
4. Determine the cash flows attributable to the specific securities
held by an Enterprise, applying the Enterprise's ownership
percentage.
5. For securities not issued by the Enterprise or Ginnie Mae, reduce
cash flows by applying the Haircuts specified in section 3.5,
Counterparty Defaults, of this Appendix.
[b] If a commercial information service is used for steps [a] 1
through 4 of this section, the information service may model
mortgage product types beyond those described for Whole Loans in
section 3.6, Whole Loan Cash Flows, and ARM indexes in addition to
those listed in section 3.3, Interest Rates, of this Appendix. In
such cases, the cash flows used are generated from the actual data
used by the information service for the underlying security.
3.7.3.3 Mortgage Revenue Bonds and Miscellaneous MRS
[a] Cash flows for mortgage revenue bonds and miscellaneous MRS
are computed as follows:
1. From the start of the Stress Test until the first principal
payment date at the start of the Principal Payment Window, the
security pays coupon interest at the Security Interest Rate,
adjusted as necessary according to the Security Rate Index and
Adjustment information in Table 3-58, but pays no principal.
2. During the Principal Payment Window, the security pays principal
and interest equal to the aggregate cash flow from a level pay
mortgage whose term is equal to the length of the Principal Payment
Window and whose interest rate is the Security Interest Rate. If the
Security Interest Rate is zero (as in the case of
[[Page 47859]]
zero-coupon MRBs), then the security pays principal only in level
monthly payment amounts equal to the Current Security Balance
divided by the length of the Principal Payment Window.
3. For securities not issued by the Enterprise or Ginnie Mae, reduce
cash flows by applying the Haircuts specified in section 3.5,
Counterparty Defaults, of this Appendix.
3.7.3.4 Accounting
Deferred balances are amortized as described in section 3.6.3.8,
Whole Loan Accounting Flows, of this Appendix, using the Pass-
Through Rate (or Security Interest Rate for MRBs) rather than the
Net Yield Rate. For principal-only strips and zero-coupon MRBs,
assume Allocated Interest is zero. If the conditions in section
3.6.3.8.3.1[a]3.a. of this Appendix, apply, do not realize the full
amount in the first month. Instead, amortize the deferred balances
using a straight line method over a period from the start of the
Stress Test through the latest month with a non-zero cash flow.
3.7.4 Mortgage-Related Securities Outputs
[a] The outputs for MBS and MRS Cash Flows, found in Table 3-55,
are analogous to those specified for Whole Loans in section 3.6.4,
Final Whole Loan Cash Flow Outputs, of this Appendix, which are
produced for each security for each month.
Table 3-61--Outputs for Mortgage-Related Securities
------------------------------------------------------------------------
Variable Description
------------------------------------------------------------------------
TPRm Total Principal Received in month m
= 1...RM
------------------------------------------------------------------------
TIRm Total Interest Received in month m =
1...RM
------------------------------------------------------------------------
HctAmtm Total Haircut amount in month m =
1...RM
------------------------------------------------------------------------
AEm Amortization Expense for months m =
1...RM
------------------------------------------------------------------------
[b] These outputs are used as inputs to the Operations, Taxes,
and Accounting component of the Stress Test, which prepares pro
forma financial statements. See section 3.10, Operations, Taxes, and
Accounting, of this Appendix.
3.8 Nonmortgage Instrument Cash Flows
3.8.1 Nonmortgage Instrument Overview
[a] The Nonmortgage Instrument Cash Flows component of the
Stress Test produces instrument level cash flows and accounting
flows (accruals and amortization) for the 120 months of the Stress
Test for:
1. Debt
2. Nonmortgage investments
3. Guaranteed Investment Contracts (GICs)
4. Preferred stock
5. Derivative contracts
a. Debt-linked derivative contracts
b. Investment-linked derivative contracts
c. Mortgage-linked derivative contracts
d. Derivative contracts that hedge forecasted transactions
e. Non-linked derivative contracts
[b] Although mortgage-linked derivative contracts are usually
linked to mortgage assets rather than nonmortgage instruments, they
are treated similarly to debt-linked and investment-linked
derivative contracts and, therefore, are covered in this section.
[c] Debt, nonmortgage investments, and preferred stock cash
flows include interest (or dividends for preferred stock) and
principal payments or receipts, while debt-linked, investment-
linked, and mortgage-linked derivative contract cash flows are
composed of interest payments and receipts only. Debt, nonmortgage
investments, and preferred stock are categorized in one of six
classes \2\ as shown in Table 3-62.
---------------------------------------------------------------------------
\2\ In addition to the items listed here, there are instruments
that do not fit into these categories. Additional input information
and calculation methodologies may be required for these instruments.
Table 3-62--Debt, Non-Mortgage Investments, and Preferred Stock Classifications
----------------------------------------------------------------------------------------------------------------
Classification Description
----------------------------------------------------------------------------------------------------------------
Fixed-Rate Bonds or Preferred Stock Fixed-rate securities that pay periodic interest or dividends
----------------------------------------------------------------------------------------------------------------
Floating-Rate Bonds or Preferred Stock Floating-rate securities that pay periodic interest or dividends
----------------------------------------------------------------------------------------------------------------
Fixed-Rate Asset-Backed Securities Fixed-rate securities collateralized by nonmortgage assets
----------------------------------------------------------------------------------------------------------------
Floating-Rate Asset-Backed Securities Floating-rate securities collateralized by nonmortgage assets
----------------------------------------------------------------------------------------------------------------
Short-Term Instruments Fixed-rate, short-term securities that are not issued at a discount and
which pay principal and interest only at maturity
----------------------------------------------------------------------------------------------------------------
Discount Instruments Securities issued below face value that pay a contractually fixed
amount at maturity
----------------------------------------------------------------------------------------------------------------
[d] Derivative contracts consist of interest rate caps, floors,
and swaps. The primary difference between financial instruments and
derivative contracts, in terms of calculating cash flows, is that
interest payments on financial instruments are based on principal
amounts that are eventually repaid to creditors, whereas interest
payments on derivative contracts are based on notional amounts that
never change hands. Debt- and investment-linked derivative contracts
are categorized in one of seven classes \3\ as shown in Table 3-63:
---------------------------------------------------------------------------
\3\ Ibid.
Table 3-63--Debt- and Investment-Linked Derivative Contract Classification
----------------------------------------------------------------------------------------------------------------
Classification Description of Contract
----------------------------------------------------------------------------------------------------------------
Basis Swap Floating-rate interest payments are exchanged based on different
interest rate indexes
----------------------------------------------------------------------------------------------------------------
Fixed-Pay Swap Enterprise pays a fixed interest rate and receives a floating interest
rate
----------------------------------------------------------------------------------------------------------------
Floating-Pay Swap Enterprise pays a floating interest rate and receives a fixed interest
rate
----------------------------------------------------------------------------------------------------------------
Long Cap Enterprise receives a floating interest rate when the interest rate to
which it is indexed exceeds a specified level (strike rate)
----------------------------------------------------------------------------------------------------------------
Short Cap Enterprise pays a floating interest rate when the interest rate to
which it is indexed exceeds the strike rate
----------------------------------------------------------------------------------------------------------------
Long Floor Enterprise receives a floating interest rate when the interest rate to
which it is indexed falls below the strike rate
----------------------------------------------------------------------------------------------------------------
Short Floor Enterprise pays a floating interest rate when the interest rate to
which it is indexed falls below the strike rate
----------------------------------------------------------------------------------------------------------------
[[Page 47860]]
[e] Mortgage-linked swaps are similar to debt-linked swaps
except that the notional amount of a mortgage-linked swap amortizes
based on the performance of certain MBS pools. Mortgage-linked
derivative contracts are divided into two classes \4\ as shown in
Table 3-64:
---------------------------------------------------------------------------
\4\ Ibid.
Table 3-64--Mortgage-Linked Derivative Contract Classification
----------------------------------------------------------------------------------------------------------------
Classification Description of Contract
----------------------------------------------------------------------------------------------------------------
Fixed-Pay Amortizing Swaps Enterprise pays a fixed interest rate and receives a floating interest
rate, both of which are based on a declining notional balance
----------------------------------------------------------------------------------------------------------------
Floating-Pay Amortizing Swaps Enterprise pays a floating interest rate and receives a fixed interest
rate, both of which are based on a declining notional balance
----------------------------------------------------------------------------------------------------------------
3.8.2 Nonmortgage Instrument Inputs
[a] The Nonmortgage Instrument Cash Flows component of the
Stress Test requires numerous inputs. Instrument level inputs
provided by the Enterprises in the RBC Report are listed in Table 3-
65. Many instrument classes require simulated Interest Rates because
their interest payments adjust periodically based on rates tied to
various indexes. These rates are generated as described in section
3.3, Interest Rates, of this Appendix.
Table 3-65--Input Variables for Nonmortgage Instrument Cash Flows
----------------------------------------------------------------------------------------------------------------
Data Elements Description
----------------------------------------------------------------------------------------------------------------
Amortization Methodology Code Enterprise method of amortizing deferred balances (e.g., straight line)
----------------------------------------------------------------------------------------------------------------
Asset ID CUSIP or Reference Pool Number identifying the asset underlying a
derivative position
----------------------------------------------------------------------------------------------------------------
Asset Type Code Code that identifies asset type used in the commercial information
service (e.g. ABS, Fannie Mae pool, Freddie Mac pool)
----------------------------------------------------------------------------------------------------------------
Associated Instrument ID Instrument ID of an instrument linked to another instrument
----------------------------------------------------------------------------------------------------------------
Coefficient Indicates the extent to which the coupon is leveraged or de-leveraged
----------------------------------------------------------------------------------------------------------------
Compound Indicator Indicates if interest is compounded
----------------------------------------------------------------------------------------------------------------
Compounding Frequency Indicates how often interest is compounded
----------------------------------------------------------------------------------------------------------------
Counterparty Credit Rating NRSRO's rating for the counterparty
----------------------------------------------------------------------------------------------------------------
Counterparty Credit Rating Type An indicator identifying the counterparty's credit rating as short-term
(`S') or long-term (`L')
----------------------------------------------------------------------------------------------------------------
Counterparty ID Enterprise counterparty tracking ID
----------------------------------------------------------------------------------------------------------------
Country Code Standard country codes in compliance with Federal Information
Processing Standards Publication 10-4
----------------------------------------------------------------------------------------------------------------
Credit Agency Code Identifies NRSRO (e.g., Moody's)
----------------------------------------------------------------------------------------------------------------
Current Asset Face Amount Current face amount of the asset underlying a swap
----------------------------------------------------------------------------------------------------------------
Current Coupon Current coupon or dividend rate of the instrument
----------------------------------------------------------------------------------------------------------------
Current Unamortized Discount Current unamortized premium or unaccreted discount of the instrument
----------------------------------------------------------------------------------------------------------------
Current Unamortized Fees Current unamortized fees associated with the instrument
----------------------------------------------------------------------------------------------------------------
Current Unamortized Hedge Current unamortized hedging gains or losses associated with the
instrument
----------------------------------------------------------------------------------------------------------------
Current Unamortized Other Any other unamortized items originally associated with the instrument
----------------------------------------------------------------------------------------------------------------
CUSIP__ISIN CUSIP or ISIN Number identifying the instrument
----------------------------------------------------------------------------------------------------------------
Day Count Day count convention (e.g. 30/360)
----------------------------------------------------------------------------------------------------------------
End Date The last index repricing date
----------------------------------------------------------------------------------------------------------------
EOP Principal Balance End of Period face, principal or notional, amount of the instrument
----------------------------------------------------------------------------------------------------------------
Exact Representation I