[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,

[[Page 47733]]

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

[[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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \49\ See III.A.2., Proprietary/Internal Models.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \52\ See II.B., Data.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \53\ 66 FR 18694 (April 10, 2001).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \56\ 64 FR 18114, April 13, 1999.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \57\ 64 FR 18116, April 13, 1999.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \58\ 12 U.S.C. 4611(a)(1).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \101\ 12 U.S.C. 4611(b)(2).
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    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\
---------------------------------------------------------------------------

    \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.
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    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).
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    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.
---------------------------------------------------------------------------

(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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \161\ 64 FR 18297, April 13, 1999.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \162\ Section 3.10.3.6 of the NPR2 Regulation Appendix, 64 FR 
18298-18299, April 13, 1999.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \165\ 64 FR 18298, April 13, 1999.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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.
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    \172\ 1992 Act, section 1302(2) (12 U.S.C. 4501(2)).
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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).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \180\ 12 U.S.C. 4614(d).
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

    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
ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½
                   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                     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
----------------------------------------------------------------------------------------------------------------

[[Page 47861]]

 
Index Code                               Indicates the interest rate index to which floating-rate instruments
                                          are tied (e.g., LIBOR)
----------------------------------------------------------------------------------------------------------------
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
----------------------------------------------------------------------------------------------------------------
Original Discount                        Original discount or premium amount of the instrument
----------------------------------------------------------------------------------------------------------------
Original Face                            Original face, principal or notional, amount of the instrument
----------------------------------------------------------------------------------------------------------------
Original Fees                            Fees associated with the instrument at inception
----------------------------------------------------------------------------------------------------------------
Original Hedge                           Hedging gain or loss to be amortized or accreted at inception
----------------------------------------------------------------------------------------------------------------
Original Other                           Any other amounts originally associated with the instrument to be
                                          amortized or accreted
----------------------------------------------------------------------------------------------------------------
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)
----------------------------------------------------------------------------------------------------------------
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 applied to UPB to adjust for timing differences
----------------------------------------------------------------------------------------------------------------

[[Page 47862]]

 
Unamortized Balances Scale Factor        Factor applied to Unamortized Balances to adjust for timing differences
----------------------------------------------------------------------------------------------------------------

    [b] In addition to the inputs in Table 3-65, other inputs may be 
required depending on the characteristics of the instrument modeled. 
For example, the mortgage-linked derivative contract cash flows 
require inputs describing the performance of the mortgage assets to 
which they are linked, including Single Family Default and 
Prepayment rates (See section 3.6.3.4, Single Family Default and 
Prepayment Rates, of this Appendix). Mortgage-linked derivative 
contract identification numbers (Asset IDs) are used to link the 
derivative contract to the required pool information that will be 
used to calculate the cash flows of the corresponding swap.

3.8.3  Nonmortgage Instrument Procedures

    In general, non mortgage instruments are modeled according to 
their terms. The general methodology for calculating cash flows for 
principal and interest payments is described in this section and is 
not intended to serve as definitive text for calculating all 
possible present and future complex instruments. As mentioned in 
section 3.8.2, Nonmortgage Instrument Inputs, of this Appendix, 
there are some instruments that may require additional input 
information and calculation methodologies. Simplifying assumptions 
are made for some instrument terms until they can be modeled more 
precisely.

3.8.3.1  Apply Specific Calculation Simplifications

    [a] In order to produce cash flows, accruals, or amortization of 
deferred balances, the following simplifications are used for all 
instruments to which they apply. Should the language in any other 
portion of section 3.8, Nonmortgage Instrument Cash Flows, of this 
Appendix, seem to conflict with a statement in this section, the 
language in section 3.8.3.1 takes precedence.
1. For day count methodology, use one of three methodologies 30/360, 
Actual/360, and Actual/365. All special day counts (i.e. Actual/366 
B, Actual/366 S, Actual/366 E, and Actual/Actual) are treated as 
Actual/365.
2. Set the first index reset date to the First Coupon Date. If the 
Issue Date is later than the start of the Stress Test, use the 
Current Coupon Rate to determine the interest paid from Issue Date 
to First Coupon Date. When a calculation requires a rate that occurs 
before the start of the Stress Test, use the Current Coupon Rate. 
This applies to interest accrued but not paid for the start of the 
Stress test and to rate indexes where applying a Look Back Period 
requires data prior to the start of the Stress Test.
    a. If periodic caps are zero, change them to 999.99; If periodic 
floors are greater than 1, change them to zero.
    b. For instruments which have principal balance changes other 
than those caused by compounding interest, perform calculations as 
if the principal changes occur only on coupon dates (coupon dates on 
the fixed-rate leg for swaps) on or later than the first principal 
change date.
    c. When using a rate index for a specified term in an option 
exercise rule or as an index, assume that rate is appropriate for 
the calculation. Do not convert from bond equivalent yield to 
another yield form for a discount, monthly pay, quarterly pay, semi-
annual pay or annual pay instrument.
3. When applying the option exercise rule:
    a. For zero coupon and discount securities, and zero coupon 
swaps, evaluate option exercise only on dates listed in the 
instrument's option exercise schedule. For all other instruments, 
evaluate option exercise only on coupon dates (coupon dates on the 
fixed-rate leg for swaps) later than the first option exercise date.
    b. Assume all call/put premiums/discounts are zero except for 
zero coupon instruments (including zero coupon swaps and discount 
notes). For these exceptions, when calculating a rate to compare 
with the Enterprise Cost of Funds, use the yield to maturity 
calculated by equating the face or notional amount plus the 
unamortized discount at the start of the Stress Test to the present 
value of the face or notional amount at maturity.
    c. Assume basis swaps and floating rate securities have no 
cancel, put, or call options.
    d. Haircuts are not applied to forward starting swaps.

3.8.3.2  Determine the Timing of Cash Flows

    Project payment dates from the payment date immediately prior to 
the start of the stress test according to the Payment Frequency, 
First Coupon Date, and Maturity Date.

3.8.3.3  Obtain the Principal Factor Amount at Each Payment Date

    [a] Where there is no amortization or prepayment of principal, 
the Principal Factor Amount is 1.0 for each payment date until the 
stated Maturity Date, when it becomes zero.
    [b] For debt and debt-linked derivative contracts that amortize, 
either a principal or a notional amortization schedule must be 
provided. If amortization information is unavailable, then the 
Principal Factor Amount is 1.0 for each payment date until the 
stated Maturity Date, when it becomes zero.
    [c] Monthly prepayment rates are 3.5 percent for fixed-rate and 
2.0 percent for floating-rate asset-backed securities. Furthermore, 
asset-backed securities are modeled through a commercial information 
service where possible. Instruments that cannot be modeled through 
the commercial information service are treated in accordance with 
section 3.9, Alternative Modeling Treatments, of this Appendix.
    [d] In the case of mortgage-linked derivative contracts, 
notional amounts are amortized based on the characteristics of the 
underlying pool in the manner described for principal balances of 
mortgage-backed securities held by an Enterprise in section 3.7, 
Mortgage-Related Securities Cash Flows, of this Appendix.

3.8.3.4  Calculate the Coupon Factor

    The Coupon Factor applicable to a given period, which applies to 
dividends also, depends on day count conventions used to calculate 
the interest payments for the instrument. For example, the Coupon 
Factor for a bond that pays interest quarterly based on a non-
compounded 30/360 convention would be 3 (representing the number of 
months in a quarter) times 30 days divided by 360 days, or 0.25. 
Table 3-66 lists the most common day count conventions.

                     Table 3-66--Day Count Conventions
------------------------------------------------------------------------
               Convention                   Coupon Factor Calculation
------------------------------------------------------------------------
30/360                                   Number of days between two
                                          payment dates assuming 30 days
                                          per month/360
------------------------------------------------------------------------
Actual/360                               Number of days between two
                                          payment dates/360
------------------------------------------------------------------------
Actual/365                               Number of days between two
                                          payment dates/365
------------------------------------------------------------------------
Actual/Actual                            Number of days between two
                                          payment dates/Number of days
                                          in the year
------------------------------------------------------------------------

3.8.3.5  Project Principal Cash Flows or Changes in the Notional Amount

    For all financial instruments, principal outstanding for the 
current period is determined by multiplying the Original Face by the 
Principal Factor Amount for the current period. The principal 
payment equals the amount of principal outstanding at the end of the 
previous period less the principal outstanding at the end of the 
current period, or zero if the instrument has a notional amount.

3.8.3.6  Project Interest and Dividend Cash Flows

3.8.3.6.1  Non-Complex Financial Instruments

    [a] Fixed-Rate Instruments. The current period principal 
outstanding is multiplied by the product of the Current Coupon and 
current period Coupon Factor and rounded to even 100ths of a dollar.
    [b] Zero-Coupon Bonds. Interest payments equal zero.
    [c] Discount Notes. Interest payments equal zero.

[[Page 47863]]

    [d] Floating-Rate Instruments. Interest payments are calculated 
as principal outstanding multiplied by the coupon for the current 
period. The current period coupon is calculated by adding a spread 
to the appropriate interest rate index and multiplying by the Coupon 
Factor. The coupon for the current period is set to this amount as 
long as the rate lies between the periodic and lifetime maximum and 
minimum rates. Otherwise the coupon is set to the maximum or minimum 
rate.
    [e] Interest Rate Caps and Floors. These derivative instruments 
pay or receive interest only if the underlying index is above a 
Strike Rate (for caps) or below it (for floors). Interest payments 
are based on notional amounts instead of principal amounts.
1. The interest payment on a long cap is the Original Face 
multiplied by the amount, if any, by which the index exceeds the 
Strike Rate, as defined by the equation in Table 3-67. The interest 
payment on a long floor is the Original Face multiplied by the 
amount, if any, by which the index is below the Strike Rate. 
Otherwise interest payments are zero for caps and floors. Interest 
payments are either paid or received depending on whether the 
Enterprise is in a long or short position in a cap or a floor.
2. Monthly cash flows for long caps and floors are calculated as 
illustrated in Table 3-67:

                             Table 3-67--Calculation of Monthly Cash Flows for Caps
----------------------------------------------------------------------------------------------------------------
             Instrument                         Interest Receipts                     Interest Payments
----------------------------------------------------------------------------------------------------------------
Long Cap                              (I-K)  x  N  x  D if I > K; 0 if I    0
                                        K
----------------------------------------------------------------------------------------------------------------
Long Floor                            0                                     (K-I)  x  N  x  D if I  K; 0 if I
                                                                              K
----------------------------------------------------------------------------------------------------------------

Where:

N = Original Face
K = Strike Rate
I = interest rate index
D = Coupon Factor

    [f] Swaps. A derivative contract in which counterparties 
exchange periodic interest payments. Each swap leg (pay side or 
receive side) is modeled as a separate instrument, with interest 
payments based on the same notional amount but different interest 
rates.
1. For debt- and investment-linked swaps, each leg's interest 
payment is determined in the same manner as payments for fixed-rate, 
floating-rate or zero coupon instruments as described in paragraph 
[a], [b] and [d] of this section.
2. For mortgage-linked swaps, calculate the reduction in the 
notional amount due to scheduled monthly principal payments (taking 
into account both lifetime and reset period caps and floors), 
Prepayments, and Defaults of the reference MBS or index pool. Reduce 
the notional amount of the swap for the previous period by this 
amount to determine the notional amount for the current period. 
Calculate interest payments or receipts for a given period as the 
product of the notional amount of the swap in that period, the 
coupon, and the Coupon Factor applicable for that period.

3.8.3.6.2  Complex Financial Instruments

    [a] Some instruments have more complex or non-standard features 
than those described in section 3.8.3.6.1, Non-Complex Financial 
Instruments, of this Appendix. These complexities can include more 
sophisticated variants of characteristics such as principal or 
notional amortization schedules, interest accrual methodologies, 
coupon reset formulas, and option features. In these instances, 
additional information may be required to completely specify the 
contractual cash flows or a proxy treatment for these instruments.
    [b] An example of an instrument with complex features is an 
indexed amortizing swap. This instrument is non-standard because its 
notional amount declines in a way that is related to the level of 
interest rates. Its amortization table contains a notional amount 
reduction factor for a given range of interest rates. To compute 
cash flows for this instrument, reduce the notional amount on each 
payment date as specified in the amortization table. (The notional 
amount at the beginning of the Stress Period is given as an input to 
the calculation.)
    [c] Special treatment is also required for foreign-currency-
linked notes, the redemption value of which is tied to a specific 
foreign exchange rate. These require special treatment because the 
Stress Test does not forecast foreign currency rates. If these 
instruments are currency-hedged, then the note plus the hedge 
comprise a synthetic debt instrument for which only the pay side of 
the swap is modeled. If these instruments are not currency-hedged, 
the following treatment applies:
1. In the up-rate scenario, the U.S. dollar per unit of foreign 
currency ratio is increased in proportion to the increase in the 
ten-year CMT; therefore, the amount of an interest or principal 
payment is increased accordingly. For example, if the ten-year CMT 
shifts up by 50 percent, then the U.S. dollar per unit of foreign 
currency ratio shifts up by 50 percent. In the Stress Test, the 
payment would be multiplied by 1.5.
2. In the down-rate scenario, the foreign currency per U.S. dollar 
ratio is decreased in proportion to the decrease in the ten-year 
CMT.
    [d] If a financial instrument's inputs are described in section 
3.1, Data, of this Appendix, then model the instrument according to 
its terms; however, the Director reserves the authority to determine 
a more appropriate treatment if modeling the instrument according to 
its terms does not capture the instrument's impact on Enterprise 
risk. If the financial instrument's inputs are not described in 
section 3.1, then treat it as described in section 3.9, Alternative 
Modeling Treatments, of this Appendix.

3.8.3.7  Apply Call, Put, or Cancellation Features, if Applicable

    [a] In some cases, principal and interest cash flows may be 
altered due to options imbedded in individual financial instruments. 
Securities can be called or put and contracts can be cancelled at 
the option of the Enterprise or the counterparty. The Option Type, 
Exercise Convention Type, and the Start Date determine when an 
option may be exercised. There are three standard Exercise 
Convention Types, all of which are accommodated in the Stress Test:
 American--Exercise can occur at any time after the Start 
Date of the option.
 European--Exercise can occur only on the Start Date of the 
option.
 Bermudan--Exercise can occur only on specified dates, 
usually on coupon payment dates between the Start Date of the option 
and maturity.
    [b] The options are treated in the following manner for each 
date on which the option can be exercised:
1. Project cash flows for the instrument with the imbedded option 
assuming that the option is not exercised. If the instrument is tied 
to an index, assume that the index remains constant at its value on 
that date.
2. Determine the discount rate that equates the outstanding balance 
of the security plus option premium and accrued interest to the sum 
of the discounted values of the projected cash flows. This discount 
rate is called the yield-to-maturity.
3. Convert the yield-to-maturity to a bond-equivalent yield and 
compare the bond-equivalent yield with the projected Enterprise Cost 
of Funds for debt with an equivalent maturity. Interpolate linearly 
if the maturity is not equal to one of the maturities specified in 
section 3.3, Interest Rates, of this Appendix.
4. If the equivalent-maturity Enterprise Cost of Funds is lower 
(higher) than 50 basis points below (above) the bond-equivalent 
yield of the callable (putable) instrument, then the option is 
exercised. Otherwise, the option is not exercised, and it is 
evaluated at the next period when the option can be exercised.
    [c] Some swap derivative contracts have cancellation features 
that allow either counterparty to terminate the contracts on certain 
dates. The cancellation feature is evaluated by comparing the fixed-
rate leg of the swap to the Enterprise Cost of Funds. If either leg 
of the swap is cancelled, then the other leg is cancelled 
concurrently. Cancellable swaps are treated in the following manner:

[[Page 47864]]

1. For each period when an option can be exercised, compare the 
swap's fixed-leg coupon rate to the Enterprise Cost of Funds with a 
maturity equivalent to the maturity date of the swap.
2. If the option is a Call, it is deemed to be exercisable at the 
discretion of the Enterprise. If the option is a Put, it is deemed 
to be exercisable at the discretion of the Counterparty. If the 
option is a PutCall, it is deemed to be exercisable at the 
discretion of either party to the swap. Exercise the option when the 
swap is out of the money for the party who holds the option. A swap 
is considered out of the money when the rate on its fixed leg is at 
least 50 basis point higher or lower, depending upon whether the 
fixed rate is paid or received, than the like-maturity Enterprise 
Cost of Funds. For zero coupon swaps in all option exercise periods, 
use the yield to maturity calculated by equating the notional amount 
plus the unamortized discount at the start of the Stress Test to the 
present value of the notional amount at maturity.
    a. For example, if the Enterprise holds a call option for a 
fixed-pay swap and the coupon rate on the fixed-pay leg is at least 
50 basis points above the Enterprise cost of funds for a maturity 
equivalent to that of the swap, then cancel the swap. Otherwise, the 
swap is not cancelled and it is evaluated the next time that the 
swap can be cancelled.

3.8.3.8  Calculate Monthly Interest Accruals for the Life of the 
Instrument

    [a] Monthly interest accruals are calculated by prorating the 
interest cash flows on an actual-day basis. In this section, the 
term ``from'' means from and including, ``to'' means up to and not 
including, and ``through'' means up to and including. As an example, 
from the first to the third of a month is two days from the first 
through the third is three days. This convention is used to 
facilitate the day count and does not imply on which day's payments 
or accruals are actually made. Use one of the three following 
methodologies with the exception that interest cash flow dates 
occurring on or after the 30th of a month are considered as 
occurring on the last day of the month:
1. If the final interest cash flow occurs within the month, the 
interest accrual for that month is calculated by multiplying the 
final interest cash flow amount (as calculated in section 3.8.3.6 of 
this Appendix) times the number of days from the beginning of the 
month through the final maturity date divided by the number of days 
from the previous interest cash flow date to the maturity date.
2. If an interest cash flow other than the final interest cash flow 
occurs within a month, the interest accrual for that month is 
determined by multiplying the interest cash flow amount for the 
current month times the number of days from the beginning of the 
month through the interest cash flow date, divided by the number of 
days from the previous interest cash flow date (or issue date) to 
this interest cash flow date. To this add the interest cash flow 
amount for the next interest cash flow date times the number of days 
from the current month's interest cash flow date to the end of the 
month, divided by the number of days from the current month's 
interest cash flow date to the following next interest cash flow 
date.
3. If no interest cash flows occur during a month other than the 
issue month, the monthly interest accrual is calculated by 
multiplying the next interest cash flow amount times the number of 
days in the month divided by the number of days from the previous 
interest cash flow date to the next interest cash flow date.
4. If the issue month occurs after the start of the Stress Test, the 
monthly interest accrual is calculated by multiplying the next 
interest cash flow amount by the number of days in the month minus 
the day of issue, divided by the number of days from the issue date 
to the next interest cash flow date.

3.8.3.9  Calculate Monthly Amortization (Accretion) of Premiums 
(Discounts) and Fees

    [a] Adjust monthly interest accruals (see section 
3.10.3.6.1[a]3., of this Appendix) to reflect the value over time of 
discounts, premiums, fees and hedging gains and losses incurred 
(Deferred Balances). Amortize Deferred Balances that exist at the 
beginning of the Stress Test until the instrument's Maturity Date. 
If there are any put, call, or cancel options that are executed, 
amortize any remaining Deferred Balances in the execution month.

                         Table 3-68--Inputs for Nonmortgage Instrument Accounting Flows
----------------------------------------------------------------------------------------------------------------
           Variable                           Description                                 Source
----------------------------------------------------------------------------------------------------------------
MD                              Maturity Date                            Table 3-65, Input Variables for
                                                                          Nonmortgage Instrument Cash Flows
----------------------------------------------------------------------------------------------------------------
UDB0                            The sum of Current Unamortized           Table 3-65, Input Variables for
                                 Discount, Current Unamortized Hedge,     Nonmortgage Instrument Cash Flows
                                 and Current Unamortized Other
                                 (Deferred Balances) for the instrument
                                 at the start of the Stress Test
----------------------------------------------------------------------------------------------------------------
MACRUm                          Monthly Interest Accruals                section 3.8.3.8, Calculate Monthly
                                                                          Interest Accruals for the Life of the
                                                                          Instrument
----------------------------------------------------------------------------------------------------------------
EOMPBAOm                        Principal Balance at the end of the      section 3.8.3.6, Project Interest and
                                 month for months m = 0...RM after        Dividend Cash Flows
                                 modeling all options execution
----------------------------------------------------------------------------------------------------------------
EOMPBm                          Principal Balance at the end of the      section 3.8.3.6, Project Interest and
                                 month for months m = 0...RM before       Dividend Cash Flows
                                 modeling any options execution
----------------------------------------------------------------------------------------------------------------

1. Compute Remaining Term (RM) as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.106

Where:

STDT is the Starting Date of the Stress Test

2. For nonmortgage instruments with notional principal, calculate 
the monthly Amortization Amount (AAm) for each month m = 
1...RM:
[GRAPHIC] [TIFF OMITTED] TR13SE01.107

3. For nonmortgage instruments with principal and interest payments,
    a. Compute Allocated Interest for all months m (AIm) 
as follows:
[GRAPHIC] [TIFF OMITTED] TR13SE01.108

    b. 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 
instrument. Solve for IRR such that:

[[Page 47865]]

[GRAPHIC] [TIFF OMITTED] TR13SE01.109

Where:

BV0 = EOMPB0 + UPD0
ACFm = EOMPBm-1 - EOMPBm + 
AIm

    c. Calculate the monthly Amortization Amount (AAm) 
for each month m = 1...RM:
[GRAPHIC] [TIFF OMITTED] TR13SE01.110

4. For discount notes,
    a. Calculate Remaining Maturity in Actual Days (RMD):
    [GRAPHIC] [TIFF OMITTED] TR13SE01.111
    
    b. Calculate the month Amortization Amount (AAm) for 
each month m = 1...RM:
[GRAPHIC] [TIFF OMITTED] TR13SE01.112

Where:

ADAYSm = actual number of days in month m (days from the 
first of the month through maturity in month RM)

5. For zero coupon bonds,
    a. Calculate Remaining Maturity in Actual Days (RMD):
    [GRAPHIC] [TIFF OMITTED] TR13SE01.114
    
    b. Calculate Yield Factor (YF):
    [GRAPHIC] [TIFF OMITTED] TR13SE01.115
    
    c. Calculate the monthly Amortization Factor (AFm) 
for each month m = 1...RM:
[GRAPHIC] [TIFF OMITTED] TR13SE01.116

Where:

ADAYSm = actual number of days in month m (days from the 
first of the month through maturity in month RM):

    d. Calculate the monthly Amortization Amount (AAm) 
for each month m = 1...RM
[GRAPHIC] [TIFF OMITTED] TR13SE01.117

3.8.3.10  Apply Counterparty Haircuts

    [a] Finally, the interest and principal cash flows received by 
the Enterprises for non-mortgage instruments other than swaps and 
foreign currency-related instruments are Haircut (i.e., reduced) by 
a percentage to account for the risk of counterparty insolvency. The 
amount of the Haircut is calculated based on the public rating of 
the counterparty and time during the stress period in which the cash 
flow occurs, as specified in section 3.5, Counterparty Defaults, of 
this Appendix.
    [b] An Enterprise may issue debt denominated in, or indexed to, 
foreign currencies, and eliminate the resulting foreign currency 
exposure by entering into currency swap agreements. The combination 
of the debt and the swap creates synthetic debt with principal and 
interest payments denominated in U.S. dollars. Because the Stress 
Test does not forecast foreign exchange rates, the counterparty 
(foreign-denominated) payments are not computed explicitly, and 
therefore cannot be Haircut explicitly in the calculation. No 
Haircut percentage is applied to the Enterprise's payments.
    [c] Haircuts for swaps that are not foreign currency related are 
applied to the Monthly Interest Accruals (as calculated in section 
3.8.3.8, of this Appendix) on the receive leg minus the Monthly 
Interest Accruals on the pay leg when this difference is positive.

3.8.4  Nonmortgage Instrument Outputs

    [a] Outputs consist of cash flows and accounting information for 
debt, nonmortgage investments, preferred stock, and derivative 
contracts. Cash flows and accounting information outputs are inputs 
to section 3.10, Operations, Taxes, and Accounting, of this 
Appendix.
    [b] Cash flows include the following monthly amounts:
1. Interest and principal payments for debt and nonmortgage 
investments,
2. Dividends and redemptions for preferred stock, and
3. Interest payments for debt-linked, investment-linked, and 
mortgage-linked derivative contracts.
    [c] Accounting information includes the following monthly 
amounts:
1. Accrued interest and
2. Amortization of discounts, premiums, fees and other deferred 
items.

3.9  Alternative Modeling Treatments

3.9.1  Alternative Modeling Treatments Overview

    [a] This section provides treatment for items that cannot be 
modeled in one of the ways specified in paragraph [b] of this 
section, but must be included in order to run the Stress Test. 
Because the rule provides treatments for a wide variety of 
instruments and activities that can be applied to accommodate 
unusual instruments, OFHEO expects few items to fall into this 
category.
    [b] An Alternative Modeling Treatment (AMT) applies to any on- 
or off-balance-sheet item that is missing data elements required to 
calculate appropriate cash flows, or any instrument with unusual 
features for which this Appendix does not:
1. Provide an explicit computational procedure and set of inputs 
(i.e., the Appendix specifies exact data inputs and procedures for a 
class of instruments to which the item belongs); or,
2. Provide an implicit procedure (used for a general class of 
instruments), and explicit inputs that allow the item to be fully 
characterized for computational purposes (i.e., the Appendix 
specifies procedures and data inputs for a class of instruments to 
which the item does not belong that can be applied to the item to 
accurately compute its cash flows); or
3. Provide an implicit procedure by exact substitution, i.e., by 
representing the item as a computationally equivalent combination of 
other items that are specified in paragraphs (1) or (2) in this 
section (i.e., the Appendix specifies treatments for two or more 
instruments, which, in combination, exactly produce the item's cash 
flows); or
4. Permit the approximation of one or more computational 
characteristics by other similar values that are explicitly 
specified in this Appendix, or in the RBC Report instructions (i.e., 
the Appendix specifies a treatment, or combination of treatments, 
that can be used as a reasonable proxy for the computational 
characteristics of the item). Such proxy treatments must be approved 
by OFHEO. OFHEO may, in its discretion, approve a proposed proxy 
treatment, adopt a different proxy treatment, or treat items for 
which a proxy treatment has been proposed by the Enterprises 
according to the remaining provisions of section 3.9, Alternative 
Modeling Treatments, of this Appendix.
    [c] For a given on- or off-balance sheet item, the appropriate 
AMT is determined according to the categories specified in section 
3.9.3, Alternative Modeling Treatments Procedures, of this Appendix, 
based on the information available for that item. The output for 
each such item is a set of cash and accounting flows, or specific 
amounts to be applied in section 3.12, Calculation of the Risk-Based 
Capital Requirement, of this Appendix.

3.9.2  Alternative Modeling Treatments Inputs

    Table 3-69 identifies the minimal inputs that are used to 
determine an AMT. (See also section 3.1, Data, of this Appendix)

[[Page 47866]]



            Table 3-69--Alternative Modeling Treatment Inputs
------------------------------------------------------------------------
            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
------------------------------------------------------------------------

3.9.3  Alternative Modeling Treatments Procedures

    For each item, one of the following alternatives will be 
applied:

3.9.3.1  Off-Balance Sheet Items

    [a] If the item is a guarantee of a tax-exempt multifamily 
housing bond, or a single family or multifamily whole-loan REMIC 
class rated triple-A, or other similar transaction guaranteed by the 
Enterprises, multiply the face value of the guaranteed instruments 
by 0.45 percent. This amount is added to the amount of capital 
required to maintain positive total capital throughout the ten-year 
Stress Period. Any instruments or obligations with 100 percent of 
collateral guaranteed by the Federal Housing Administration (FHA) 
are excluded from this calculation.
    [b] Otherwise, add to the amount of capital required to maintain 
positive total capital throughout the ten-year Stress Period an 
amount equal to the face or notional value of the item at the 
beginning of the Stress Period times three percent.

3.9.3.2  Reconciling Items

    Reconciling items falling into this category will be treated 
according to the specifications in section 3.10, Operations, Taxes, 
and Accounting, of this Appendix.

3.9.3.3  Balance Sheet Items

    [a] If the item is a trading security recorded at fair value 
according to FAS 115, then the book value (the face value adjusted 
for deferred balances) will be converted to cash in the first month 
of the Stress Test.
    [b] Otherwise, if the item is an earning asset, then it is 
treated as a held-to-maturity asset, based on book value, as 
follows:
1. In the up-rate scenario, it will be treated as a held-to-maturity 
bond paying compound interest on a 30/360 basis at maturity, with 
the item's contractual maturity and rate. The item will be Haircut 
according to its rating. If no maturity is provided, maturity will 
be set at 120 months. If no rate is provided, a rate will be 
assigned at the Initial Enterprise Cost of Funds whose term is equal 
to the remaining maturity, less 200 basis points (but not less than 
zero). If no rating is provided, the asset will be classified as 
unrated.
2. In the down-rate scenario, it will be treated as a held-to-
maturity bond paying compound interest on a 30/360 basis at 
maturity, with the item's contractual maturity and rate. The item 
will be Haircut according to its rating. If no maturity is provided, 
maturity will be set at 120 months. If no rate is provided, a rate 
will be assigned at the floating one-month Enterprise Cost of Funds 
less 200 basis points (but not less than zero). If no rating is 
provided, the asset will be classified as unrated.
    [c] If the item is a non-earning asset it will remain on the 
books and earn no interest throughout the Stress Period.
    [d] Otherwise, if the item is a liability, then it is treated as 
follows, based on book value:
1. In the up-rate scenario, it will be treated as non-callable and 
monthly coupon-paying to maturity on a 30/360 basis. If the coupon 
rate is not specified, the liability will be given a floating rate 
at the one-month Enterprise Cost of Funds plus 200 basis points. If 
no maturity is provided, maturity will be set at 120 months.
2. In the down-rate scenario, it will be treated as non-callable and 
monthly coupon paying to maturity. If no coupon is provided, the 
liability will be given a fixed rate at the Initial Enterprise Cost 
of Funds plus 200 basis points. If no maturity is provided, maturity 
will be set at ten years.
    [e] Unamortized Balances should be amortized on a straight-line 
basis over the designated remaining maturity of the instrument.
    [f] All items in this section are treated as if they had no 
options or cancellation features. The face value will be held 
constant until maturity. If an item has an adjustable rate, it is 
assumed that the interest rate will adjust monthly with no caps and 
a lifetime floor of zero percent.

3.9.4  Alternative Modeling Treatments Outputs

    For each AMT item, the output is a set of cash and accounting 
flows appropriate to its respective treatment as specified in 
section 3.9.3, Alternative Modeling Treatments Procedures, or 
specific amounts to be applied in section 3.12, Calculation of the 
Risk-Based Capital Requirement, of this Appendix.

3.10  Operations, Taxes, and Accounting

3.10.1  Operations, Taxes, and Accounting Overview

    This section describes the procedures for determining new debt 
issuance and investments, computing capital distributions, 
calculating operating expenses and taxes, and creating pro forma 
balance sheets and income statements. Input data include an 
Enterprise's balance sheet at the beginning of the Stress Period, 
interest rates from the Interest Rates component of the Stress Test, 
and the outputs from cash flow components of the Stress Test. The 
outputs of the procedures discussed in this section--monthly pro 
forma balance sheets, cash flow and income statements for each month 
of the Stress Test--are the basis for the capital calculation 
described in section 3.12, Calculation of the Risk-Based Capital 
Requirement, of this Appendix.

3.10.2  Operations, Taxes, and Accounting Inputs

    [a] Data described in section 3.1, Data, section 3.3.4, Interest 
Rates Outputs, section 3.6.4, Final Whole Loan Cash Flow Outputs, 
section 3.7.4, Mortgage-Related Securities Outputs, and section 
3.8.4, Nonmortgage Instrument Outputs, of this Appendix, is used to 
produce monthly pro forma balance sheets and income statements for 
the Enterprises. In addition to the starting position data, 
described in the cash flow components, the Enterprises provide the 
starting position dollar values for the items in Table 3-70.

[[Page 47867]]



          Table 3-70--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
------------------------------------------------------------------------
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
------------------------------------------------------------------------

[[Page 47868]]

 
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 multifamily 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
------------------------------------------------------------------------
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
------------------------------------------------------------------------

[[Page 47869]]

 
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
 receivable
------------------------------------------------------------------------

    [b] Amounts required to reconcile starting position balances 
from cash flow components of the Stress Test with an Enterprise's 
balance sheet will be reported in the RBC Report with the related 
instrument. The corresponding balance for the related instrument 
will be adjusted accordingly.

3.10.3 Operations, Taxes, and Accounting Procedures

    The Stress Test calculates new debt and investments, dividends, 
allowances for loan losses, operating expenses, and income taxes. 
These calculations are determined by, and also affect, the pro forma 
balance sheets and income statements during the Stress Period.

3.10.3.1 New Debt and Investments

    [a] For each month of the Stress Test, cash deficits and 
surpluses are eliminated by issuing new debt or purchasing new 
investments. The Stress Test calculates cash received and cash 
disbursed each month in order to determine the net availability of 
cash. Depending on the calculated net cash position at month end, 
new short term investments are purchased at mid-month or a mix of 
long and short term debt is issued at mid-month so that the 
recalculated net cash position at month end is zero.
    [b] For each month of the Stress Test, the following 
calculations are performed to determine the amount and type of new 
debt and investments. The short-term investments and appropriate mix 
of long-term and short-term debt are reflected in the pro forma 
balance sheets. Interest income or interest expense for the new 
investments or debt are reflected in the pro forma income 
statements.
1. In any month in which the cash position is positive at the end of 
the month, the Stress Test invests the Enterprise's excess cash on 
the 15th day of that month in one-month Treasury bills that yield 
the six-month Treasury rate for that month as specified in section 
3.3, Interest Rates, of this Appendix.
2. In any month in which the cash position is negative at the end of 
the month, the Stress Test issues a mix of new short-term and long-
term debt on the 15th day of that month. New short-term debt issued 
is six-month discount notes with a discount rate at the six-month 
Enterprise Cost of Funds as specified in section 3.3, Interest 
Rates, of this Appendix, with interest accruing on a 30/360 basis. 
New long-term debt issued is five-year bonds not callable for the 
first year (``five-year-no call-one'') with an American call at par 
after the end of the first year, semiannual coupons on a 30/360 
basis with principal paid at maturity or call, and a coupon rate set 
at the five year Enterprise Cost of Funds as specified in section 
3.3, Interest Rates, of this Appendix, plus a 50 basis point premium 
for the call option. An issuance cost of 2.5 basis points is 
assessed on new short-term debt at issue and an issuance cost of 20 
basis points is assessed on new long-term debt at issue. New short-
term debt is issued in a manner so that the existing short-term debt 
plus the newly issued short-term debt does not exceed fifty percent 
of the sum of all existing debt and total new debt issued. Issuance 
fees for new debt are amortized on a straight line basis to the 
maturity of the appropriate instrument.
3. Given the Net Cash Deficit (NCDm) in month m, use the 
following method to calculate the amount of short-term and long-term 
debt to issue in month m:
    a. Calculate Discount Rate Factor (DRFm):
    [GRAPHIC] [TIFF OMITTED] TR13SE01.118
    
Where:

CFm = six month Enterprise Cost of Funds for month m

    b. Calculate the Adjustment Factor for Short-Term Debt Issuance 
Fees (AFSIFm):
[GRAPHIC] [TIFF OMITTED] TR13SE01.119

    c. Calculate the Maximum Short-Term Issuance (MSTIm):
    [GRAPHIC] [TIFF OMITTED] TR13SE01.120
    
    d. Calculate New Short-Term Debt Outstanding (NSDOm):
    [GRAPHIC] [TIFF OMITTED] TR13SE01.121
    
Where:

 SDOm = remaining principal balance of all debt maturing 
or repricing within the next twelve months;
 PSm = remaining notional balances of the receive side of 
swaps maturing or repricing within the next twelve months;
RSm = remaining notional balances of the pay side of 
swaps maturing or repricing within the next twelve months.
    e. Calculate Face Amount of Short-Term Debt to be issued this 
month (FASDm):

[[Page 47870]]

[GRAPHIC] [TIFF OMITTED] TR13SE01.122

Where:

TDOm = remaining principal balance of all debt 
outstanding at the end of this month

  f. Calculate Face Amount of Long-Term Debt to be issued 
(FALDm):
[GRAPHIC] [TIFF OMITTED] TR13SE01.123

3.10.3.2  Dividends and Share Repurchases

    [a] The Stress Test determines quarterly whether to pay 
dividends and make share repurchases. Dividends are decided upon and 
paid during the first month after the end of the quarter for which 
they are declared. If any dividends are paid, the dividend payout 
cannot exceed an amount equal to core capital less the estimated 
minimum capital requirement at the end of the quarter. Share 
repurchases are made during the middle month of the quarter.
1. Preferred Stock. An Enterprise will pay dividends on preferred 
stock as long as that Enterprise meets the estimated minimum capital 
requirement before and after the payment of these dividends. 
Preferred stock dividends are based on the coupon rates of the 
issues outstanding. The coupon rates for any issues of variable rate 
preferred stock are calculated using projections of the appropriate 
index rate. Preferred stock dividends may not exceed core capital 
less the estimated minimum capital requirement at the end of the 
preceding quarter.
2. Common Stock. In the first year of the Stress Test, dividends are 
paid on common stock in each of the four quarters after preferred 
dividends, if any, are paid unless the Enterprise's capital is, or 
after the payment, would be, below the estimated minimum capital 
requirement.
    a. First Quarter. In the first quarter, the dividend is the 
dividend per share ratio for common stock from the quarter preceding 
the Stress Test (adjusted by the ratio of Enterprise retained 
earnings and retained earnings after adjustments are made that 
revert investment securities and derivatives to amortized cost) 
times the current number of shares of common stock outstanding.
    b. Subsequent Quarters.
    1) In the three subsequent quarters, if the preceding quarter's 
after tax income is greater than after tax income in the quarter 
preceding the Stress Test, pay the larger of (1) the dividend per 
share ratio for common stock from the quarter preceding the Stress 
Test (adjusted by the ratio of Enterprise retained earnings and 
retained earnings after adjustments are made that revert investment 
securities and derivatives to amortized cost) times the current 
number of shares of common stock outstanding or (2) the average 
dividend payout ratio for common stock for the four quarters 
preceding the start of the Stress Test times the preceding quarter's 
after tax income (adjusted by the ratio of Enterprise retained 
earnings and retained earnings after adjustments are made that 
revert investment securities and derivatives to amortized cost) less 
preferred dividends paid in the current quarter. In no case may the 
dividend payment exceed an amount equal to core capital less the 
estimated minimum capital requirement at the end of the preceding 
quarter.
    2) If the previous quarter's after tax income is less than or 
equal to after tax income in the quarter preceding the Stress Test 
(adjusted by the ratio of Enterprise retained earnings and retained 
earnings after adjustments are made that revert investment 
securities and derivatives to amortized cost), pay the lesser of (1) 
the dividend per share ratio for common stock for the quarter 
preceding the Stress Test times the current number of shares of 
common stock outstanding or (2) an amount equal to core capital less 
the estimated minimum capital requirement at the end of the 
preceding quarter, but not less than zero.
3. Share Repurchases. In the first two quarters of the Stress Test, 
the capital of the Enterprises will be reduced to reflect the 
repurchase of shares. The amount of the capital reduction in each of 
those two quarters will be equal to the average net stock 
repurchases by the Enterprise during the four quarters preceding the 
start of the Stress Period. Net stock repurchases equal repurchases 
less receipts from new stock issued, but not less than zero. 
Repurchases in each of the first two quarters may occur only up to 
the point that the amount of core capital exceeds the estimated 
minimum capital requirement at the end of the first month of the 
quarter.
4. Minimum Capital Requirements. For the purposes of the Stress 
Test, the Enterprise's minimum capital requirement is computed by 
applying leverage ratios to all assets (2.50 percent) and off-
balance sheet obligations (0.45 percent), and summing the results. 
Repurchases of an Enterprise's own previously-issued MBSs are 
excluded from the minimum capital calculation used in section 
3.10.3.2, Dividends and Share Repurchases, of this Appendix.

3.10.3.3  Allowances for Loan Losses and Other Charge-Offs

    [a] The Stress Test calculates a tentative allowance for loan 
losses monthly by multiplying current-month Credit Losses (CL in 
Table 3-52) by twelve, thus annualizing current month Credit Losses. 
This is a proxy for a loss contingency where it is probable that a 
loss has been incurred and the amount can be reasonably estimated. 
For both the retained and sold portfolios, these credit losses 
include lost principal (net of recoveries from credit enhancements 
and disposition of the real estate collateral), and foreclosure, 
holding, and disposition costs. If the tentative allowance for loan 
losses for the current period is greater than the balance from the 
prior month less charge-offs (i.e., credit losses) for the current 
month, a provision (i.e., expense) is recorded. Otherwise, no 
provision is made and the allowance for loan losses is equal to the 
prior period amount less current month charge-offs.
    [b] Other charge-offs result from Haircuts related to mortgage 
revenue bonds, private-issue MBS, and non mortgage investments, 
described in their respective cash flow components.
1. In the case of Enterprise investments in securities, these 
Haircuts result in the receipt of less principal and interest than 
is contractually due. Lost principal is recorded as Other Losses 
when due and not received, while lost interest is recorded as a 
reduction of Interest Income.
2. In the case of interest rate derivative instruments, these 
Haircuts result in the receipt of less net interest than is 
contractually due from, or the payment of more interest than is 
contractually due to, an Enterprise counterparty. For those swaps 
that are linked to Enterprise investments, the increase or decrease 
of net swap interest due is recorded as an adjustment of Interest 
Income. For those swaps that are linked to Enterprise debt 
obligations, the increase or decrease of net swap interest due is 
recorded as an adjustment of Interest Expense.

3.10.3.4  Operating Expenses

    [a] The Stress Test calculates operating expenses, which include 
non-interest costs such as those related to an Enterprise's salaries 
and benefits, professional services, property, equipment and office 
space. Over the Stress Period, operating expenses are equal to the 
sum of two components. The first component in each month is equal to 
one-third (\1/3\) of the average monthly operating expenses of the 
Enterprise in the quarter immediately preceding the start of the 
Stress Test. The second component changes in proportion to the 
change in the

[[Page 47871]]

size of the Enterprise's mortgage portfolio (i.e., the sum of 
outstanding principal balances of its retained and sold mortgage 
portfolios). The Stress Test calculates the Enterprise's mortgage 
portfolio at the end of each month of the Stress Period as a 
percentage of the portfolio at the start of the Stress Test, and 
then multiplies the percentage of assets remaining by two-thirds 
(\2/3\) of the average monthly operating expenses of the Enterprise 
in the quarter immediately preceding the start of the Stress Test.
    [b] The sum of the two components in paragraph [a], of this 
section, is multiplied by a factor which equals
[GRAPHIC] [TIFF OMITTED] TR13SE01.124

for the first 12 months of the Stress Test and then equals two-
thirds for months 13 and beyond. This product is the Enterprise's 
operating expense for a given month in the Stress Period.

3.10.3.5  Income Taxes

    [a] Both Enterprises are subject to Federal income taxes, but 
neither is subject to state or local income taxes.
    [b] The Stress Test applies an effective Federal income tax rate 
of 30 percent when calculating the monthly provision for income 
taxes (e.g., income tax expense). OFHEO may change the 30 percent 
income tax rate if there are significant changes in Enterprise 
experience or changes in the statutory income tax.
    [c] The Stress Test sets income tax expense for tax purposes 
equal to the provision for income taxes. The effects of timing 
differences between taxable income and Generally Accepted Accounting 
Principles (GAAP) income before income taxes are ignored. Income 
before taxes is adjusted by the ratio of Enterprise retained 
earnings and retained earnings after adjustments are made that 
revert investment securities and derivatives to amortized cost. 
Therefore, Net Operating Loss (NOL) occurs only when the net income, 
before the provision for income taxes, is negative.
    [d] Payments for estimated income taxes are made quarterly, in 
the month after the end of the quarter. At the end of each year, the 
annual estimated tax amount is compared to the annual actual tax 
amount. In March of the next year, a payment of remaining taxes is 
made or a refund for overpayment of income taxes is received.
    [e] The NOL for the current year is ``carried back'' to offset 
taxes in any or all of the preceding two calendar years. (The 
Enterprises' tax year is the same as the calendar year.) This offset 
of the prior years' taxes results in a negative provision for income 
taxes (e.g., income) for the current year. Use of a carry back 
reduces available carry backs in subsequent years. Any NOL remaining 
after carry backs are exhausted becomes a carry forward.
    [f] Carry forwards represent NOLs that cannot be carried back to 
offset previous years' taxes, but can be used to offset taxes in any 
or all of the subsequent 20 years. Carry forwards accumulate until 
used, or until they expire 20 years after they are generated.
    [g] A valuation adjustment is used to eliminate any deferred tax 
asset.

3.10.3.6  Accounting

    [a] The 1992 Act specifies that total capital includes core 
capital and a general allowance for foreclosure losses. For the 
Enterprises, this general allowance is represented by general 
allowances for loan losses on their retained and sold mortgage 
portfolios. As defined at 12 CFR 1750.2, core capital includes the 
sum of the following components of equity:
1. The par or stated value of outstanding common stock,
2. The par or stated value of outstanding perpetual, noncumulative 
preferred stock,
3. Paid-in capital, and
4. Retained earnings.
    [b] In order to determine the amount of total capital an 
Enterprise must hold to maintain positive total capital throughout 
the ten-year Stress Period, the Stress Test projects the four 
components of equity listed in paragraph [a] of this section plus 
general loss allowances as part of the monthly pro forma balance 
sheets.
    [c] Details of an Enterprise's actual balance sheet at the 
beginning of the Stress Test are recorded from a combination of 
starting position balances for all instruments for which other 
components of the Stress Test calculate cash flows and other 
starting position balances for assets, liabilities, and equity 
accounts needed to complete an Enterprise's balance sheet.
    [d] After recording an Enterprise's balance sheet at the 
beginning of the Stress Period, the Stress Test creates monthly pro 
forma balance sheets and income statements by recording output from 
the cash flow components of the Stress Test; recording new debt and 
investments (and related interest), dividends, loss allowances, 
operating expenses, and taxes; and applying accounting rules 
pertaining to pro forma balance sheets and income statements.

3.10.3.6.1  Accounting for Cash Flows and Accounting Flows

    [a] Balances at the beginning of the Stress Test are obtained 
from the RBC Report. Subsequent changes to related pro forma balance 
sheet and income statement accounts are obtained from data generated 
by cash flow components of the Stress Test as follows:
1. Retained Loans. For Retained Loans, interest cash flows in the 
first month of the Stress Period reduce accrued interest receivable 
at the beginning of the Stress Test. Subsequent months interest cash 
flows are recorded as accrued interest receivable and interest 
income in the month prior to receipt. When the interest cash flows 
are received, accrued interest receivable is reduced. Monthly 
principal cash flows (including Prepayments and defaulted principal) 
are recorded as reductions in the outstanding balance of the loan 
group. Net losses on Defaults are charged off against the allowance 
for loan losses. Amortization of deferred discounts increases 
interest income; amortization of deferred premiums decreases 
interest income.
2. Mortgage Revenue Bonds. For mortgage revenue bonds, interest cash 
flows in the first month of the Stress Period reduce accrued 
interest receivable at the beginning of the Stress Test. Subsequent 
months' interest cash flows are recorded as accrued interest 
receivable and interest income in the month prior to receipt. When 
the interest cash flows are received, accrued interest receivable is 
reduced. Monthly principal cash flows (including Prepayments) are 
recorded in the month received as a reduction in the outstanding 
balance of mortgage assets. Defaulted principal is charged off when 
due and is not received. Amortization of deferred discounts 
increases interest income; amortization of deferred premiums 
decreases interest income.
3. Nonmortgage Instruments. Principal repayments of nonmortgage 
instruments reduce the nonmortgage instrument and increases or 
decreases cash. When the interest cash flows are received or paid, 
accrued interest receivable or payable is reduced. Accrued interest 
includes both amounts at the beginning of the Stress Period and 
subsequent monthly accruals (also recorded as interest income or 
interest expense). Amortization of deferred discounts and premiums 
increases or decreases interest income or interest expense. 
Defaulted principal is charged off when due and not received.
4. Sold Portfolio. Sold portfolio cash flows include monthly 
guarantee fees, float, and principal and interest due MBS investors. 
Guarantee fees are recorded as income in the month received. 
Principal and interest due mortgage security investors does not 
affect the balance sheet; however, interest earned on these amounts 
(float) is recorded as income in the month the underlying principal 
and interest payments are received. Principal payments received and 
defaulted loan balances reduce the outstanding balance of the sold 
portfolio. Losses (net of recoveries) are charged off against the 
allowance for losses on the sold portfolio (a liability on the pro 
forma balance sheets) and reduce cash. Amortization of deferred 
premiums and discounts increases or decreases guarantee fees.

3.10.3.6.2  Accounting for Non-Cash Items

    [a] Changes in the pro forma balances for other parts of the 
Enterprise's balance sheet not resulting from cash flows are 
recorded as described in the following nine steps:
1. Unrealized Gains and Losses.
    a. Recorded amounts in Other Comprehensive Income (OCI) that 
correspond to investments in available-for-sale securities will be 
reversed against related investment balances so as to revert 
recorded investment balances to amortized cost at the start of the 
Stress Test. Deferred amounts associated with these securities are 
amortized as described in previous sections of this document 
corresponding to the particular instrument type.
    b. The recorded value of derivative instruments (less 
unamortized amounts that, prior to the adoption of FAS 133, would 
have been amortized) that were

[[Page 47872]]

designated as Cash Flow Hedges will be reversed against OCI at the 
start of the Stress Test. The carrying value of derivative 
instruments and related hedged items (less unamortized amounts that, 
prior to the adoption of FAS 133, would have been amortized) that 
were designated Fair Value Hedges will be reversed as an increase or 
decrease in Retained Earnings at the start of the Stress Test.
    c. Recorded amounts in OCI that correspond to derivative 
transactions terminated prior to the start of the Stress Test will 
be amortized in a manner that is consistent with the amortization of 
other, deferred amounts associated with the hedged instrument.
    d. Any treatments in section 3.10.3.6.2[a]1. of this Appendix, 
are not applied to instruments that are modeled under AMT (see 
section 3.9, Alternative Modeling Treatments, of this Appendix).
2. Low Income Housing Tax Credit Investments. Low income housing tax 
credit investments at the beginning of the Stress Test are converted 
to cash on a straight line basis over the first six months of the 
Stress Period.
3. Other Assets. The following other assets at the beginning of the 
Stress Test are converted to cash as follows:
    a. Clearing accounts and other miscellaneous receivables (e.g., 
fees receivable, accounts receivable, and other miscellaneous 
assets) in the first month of the Stress Test.
    b. Earning assets (see section 3.9, Alternative Modeling 
Treatments, of this Appendix)
    c. Items not covered by a. and b. of this section on a straight-
line basis over the first five-years of the Stress Test.
4. Real Estate Owned (REO). Real estate owned at the beginning of 
the Stress Test is converted to cash on a straight-line basis over 
the first six months of the Stress Test.
5. Fixed Assets. Fixed assets (net of accumulated depreciation) as 
of the beginning of the Stress Test remain constant over the Stress 
Test. However, depreciation is included in the base on which 
operating expenses are calculated for each month during the Stress 
Period.
6. Principal and Interest Payable. Principal and interest payable to 
an Enterprise's mortgage security investors at the beginning of the 
Stress Test are paid during the first two months of the Stress Test 
(one-half in month one and one-half in month two).
7. Other Liabilities. The following liabilities at the beginning of 
the Stress Test are paid in the first month of the Stress Test, 
reducing cash:
    a. Escrow deposits
    b. Other miscellaneous liabilities
8. Commitments. No gains or losses are recorded when commitments are 
added to the Enterprise's sold portfolio. See section 3.2.1, of this 
Appendix.
9. Fully-Hedged Foreign Currency-Denominated Liabilities. Amounts 
that relate to currency swaps and foreign currency-denominated 
liabilities will be treated as follows:
    a. Recorded balances that correspond to converted foreign 
currency-denominated liabilities will be amortized in a manner that 
is consistent with scheduled pay leg exchanges of notional amounts 
as set forth in corresponding currency swaps. The unamortized 
premiums, discounts and/or fees that are associated with these 
liabilities will be amortized as described in section 3.8, of this 
Appendix, as if they were associated with the pay legs of the 
corresponding currency swap. Any differences will be reflected as an 
increase or decrease in Retained Earnings.
    b. Interest payable amounts associated with currency swaps will 
be settled in a manner that is consistent with the contractual terms 
for these instruments.
    c. Receivable amounts associated with currency swaps and 
interest payable amounts associated with foreign currency-
denominated debt will be reversed against Retained Earnings.
    d. The adjustments in a., b. and c., of this section, will take 
place at the start of the Stress Test. These treatments are not 
applied to instruments that are modeled under AMT (see section 3.9, 
Alternative Modeling Treatments, of this Appendix) or foreign 
currency-denominated instruments that are not fully hedged.

3.10.3.6.3   Other Accounting Principles

    The following additional accounting principles apply to the pro 
forma balance sheets and income statements:
1. All investment securities are treated as held to maturity. As 
such, they are recorded as assets at amortized cost, not at fair 
value.
2. All non-securitized mortgage loans will be classified as ``held-
to-maturity'' and will be accounted for on an amortized cost basis.
3. Effective control over the collateral for collateral financings 
is with the party that originally delivered such collateral.
4. Enterprise Real Estate Investment Trust (REIT) subsidiaries are 
consolidated. Specifically, REIT assets are treated as Enterprise 
assets. Preferred stock of the REIT is reflected as Enterprise debt. 
Dividends paid on the preferred stock are reported as interest 
expense.
5. Treasury stock is reflected as a reduction in retained earnings.

3.10.4  Operations, Taxes, and Accounting Outputs

    For each month of the Stress Period, the Stress Test produces a 
pro forma balance sheet and income statement. The Operations, Taxes 
and Accounting component outputs 121 monthly and 11 annual balance 
sheets, 120 monthly and 10 annual income statements, and 120 monthly 
and 10 annual cash flow statements, including part-year statements 
for the first and last calendar years of the Stress Test when 
necessary. These pro forma financial statements are the inputs for 
calculation of the risk-based capital requirement (see section 3.12, 
Calculation of the Risk-Based Capital Requirement, of this 
Appendix).

3.11  Treatment of New Enterprise Activities

3.11.1  New Enterprise Activities Overview

    [a] Given rapid innovation in the financial services industry, 
OFHEO anticipates the Enterprises will become involved with new 
mortgage products, investments, debt and derivative instruments, and 
business activities, which must be accommodated in the Stress Test 
in order to capture all of the risk in the Enterprises' businesses. 
New accounting entries resulting from these innovations and changes 
in accounting must also be accommodated. The regulation is 
sufficiently flexible and complete to address new Enterprise 
activities as they emerge, using the procedures outlined in this 
section. However, OFHEO will monitor the Enterprises' activities 
and, when appropriate, propose amendments to this regulation 
addressing the treatment of new instruments, activities, or 
accounting treatments.
    [b] For the purpose of this section of the Appendix, the term 
New Activity means any type of asset, liability, off-balance-sheet 
item, accounting entry, or activity to which a Stress Test treatment 
has not previously been applied. In addition, the Director has the 
discretion to treat as a New Activity: (1) any activity or 
instrument with characteristics or unusual features that create 
risks or hedges for the Enterprise that are not reflected adequately 
in the specified treatments for similar activities or instruments; 
and (2) any activity or instrument for which the specified treatment 
no longer adequately reflects the risk/benefit to the Enterprise, 
either because of increased volume or because new information 
concerning those risks/hedges has become available.

3.11.2  New Enterprise Activities Inputs

    [a] Complete data and full explanations of the operation of the 
New Activity sufficient to understand the risk profile of the New 
Activity must be provided by the Enterprise. The Enterprises are 
required to notify OFHEO, pursuant to Sec. 1750.2(c), of proposals 
related to New Activities as soon as possible, but in any event no 
later than five calendar days after the date on which the 
transaction closes or is settled. The Enterprises are encouraged to 
suggest an appropriate capital treatment that will fully capture the 
credit and interest rate risk in the New Activity. Information on 
New Activities must also be submitted and appropriately identified 
as such in the RBC Report.
    [b] The Stress Test will not give an Enterprise the capital 
benefit associated with a New Activity where OFHEO determines that 
the impact of that activity on the risk-based capital level of the 
Enterprise is not commensurate with the economic benefit to the 
Enterprise.

3.11.3  New Enterprise Activities Procedures

    [a] OFHEO will analyze the risk characteristics and determine 
whether an existing approach specified in the Appendix appropriately 
captures the risk of the New Activity or whether some combination or 
adaptation of existing approaches specified in the Appendix is 
appropriate. For example, the Stress Test might employ its mortgage 
performance components and adapt its cash flow components to 
simulate accurately the

[[Page 47873]]

loss mitigating effects and counterparty credit risk of credit 
derivatives.
    [b] Where there is no reasonable approach using existing 
combinations or adaptations of treatments specified in this Appendix 
that could be applied within the timeframe for computing a quarterly 
capital calculation, the Stress Test will employ an appropriately 
conservative treatment, consistent with OFHEO's role as a safety and 
soundness regulator. Such treatment may include an alternative 
modeling treatment specified in section 3.9, Alternative Modeling 
Treatments, of this Appendix, or some other conservative treatment 
that OFHEO deems more appropriate.
    [c] OFHEO will provide the Enterprise with its estimate of the 
capital treatment as soon as possible after receiving notice of the 
New Activity. In any event, the Enterprise will be notified of the 
capital treatment in accordance with the notice of proposed capital 
classification provided for in Sec. 1750.21.
    [d] After a treatment has been incorporated into a final capital 
classification, OFHEO will provide notice of such treatment to the 
public, including the other Enterprise. OFHEO will consider any 
comments it receives from the public regarding the treatment during 
subsequent quarters. OFHEO may change the treatment as a result of 
such input or otherwise, if OFHEO determines that the risks of the 
New Activity are not appropriately reflected in a treatment 
previously adopted.

3.11.4  New Enterprise Activities Outputs

    The Stress Test will generate a set of cash and/or accounting 
flows reflecting the treatment applied to the New Activity.

3.12  Calculation of the Risk-Based Capital Requirement

3.12.1  Risk-Based Capital Requirement Overview

    The risk-based capital requirement is the sum of (1) the minimum 
amount of total capital that an Enterprise must hold at the start of 
the Stress Test in order to maintain positive total capital 
throughout the ten-year Stress Period, for all financial instruments 
explicitly modeled in the Stress Test (Stress Test capital subtotal) 
and (2) certain additional amounts relating to off-balance-sheet 
items addressed in section 3.9, Alternative Modeling Treatments, of 
this Appendix, and (3) 30 percent of that sum for management and 
operations risk. The Stress Test capital subtotal is determined 
based on monthly total capital figures from the pro forma financial 
statements, the additional amounts related to off-balance-sheet 
items, and Enterprise short term borrowing and investment rates.

3.12.2  Risk-Based Capital Requirement Inputs

    [a] Inputs to the capital calculation are outputs from section 
3.3, Interest Rates, section 3.9, Alternative Modeling Treatments, 
and section 3.10, Operations, Taxes, and Accounting, of this 
Appendix.
    [b] For each month of the Stress Test, the following inputs are 
from, or used in the creation of, pro forma financial statements 
projected in section 3.10, Operations, Taxes, and Accounting, of 
this Appendix:

1. Total capital
    a. The par or stated value of outstanding common stock,
    b. The par or stated value of outstanding perpetual, 
noncumulative preferred stock,
    c. Paid-in capital,
    d. retained earnings, and
    e. allowance for losses on retained and sold mortgages less 
specific losses calculated in accordance with FAS 114,
2. Provision for income taxes (income tax expense),
3. Valuation adjustment that reduces benefits recorded from net 
operating losses when no net operating loss tax carrybacks are 
available, and
4. An Enterprise's cash position prior to the decision to issue new 
debt or purchase new investments to balance the balance sheet (see 
section 3.10.3.1, New Debt and Investments, of this Appendix).

    [c] For present-value calculations, the Stress Test uses the 
six-month Enterprise Cost of Funds or the six-month CMT yield as 
described in section 3.3, Interest Rates, of this Appendix.
    [d] The amount for off-balance-sheet items that are not 
explicitly modeled is obtained from section 3.9.3.1, Off-Balance 
Sheet Items, of this Appendix.

3.12.3  Risk-Based Capital Requirement Procedures

    [a] The following eight steps are used to determine the Stress 
Test capital subtotal and the risk-based capital requirement for an 
Enterprise:
1. Determine the effective tax rate in each month. If the provision 
for income taxes is positive (reflecting taxes owed) or negative 
(reflecting tax refunds to be received), then the effective tax rate 
is 30 percent. If the provision for income taxes is zero after 
applying any valuation adjustments (see section 3.10.3.6, 
Accounting, of this Appendix), then the effective tax rate applied 
in step 3. of this section is zero.
2. Determine whether an Enterprise is an investor or a borrower in 
each month of the Stress Period. In months where an Enterprise has 
outstanding six-month discount notes that were issued during the 
stress test, then the Enterprise is a borrower. Otherwise, the 
Enterprise is an investor.
3. Determine the appropriate monthly discount factor for each month 
of the Stress Period:
  a. In months where an Enterprise is an investor, the monthly 
discount factor is based on the yield of short-term assets:
[GRAPHIC] [TIFF OMITTED] TR13SE01.125

  b. In months where an Enterprise is a borrower, the monthly 
discount factor is based on the cost of the Enterprise's short-term 
debt:
[GRAPHIC] [TIFF OMITTED] TR13SE01.126

Where:

0.00025 is the factor that incorporates the issuance and 
administrative costs for an Enterprise's new discount notes.

4. Compute the appropriate cumulative discount for each month of the 
Stress Period. The cumulative discount factor for a given month is 
the monthly discount factor for that month multiplied by the 
cumulative discount factor for the preceding month. (The cumulative 
discount factor for the first month of the Stress Period is the 
monthly discount factor for that month.) Thus, the cumulative 
discount factor for any month incorporates all of the previous 
monthly discount factors.
5. Discount total capital for each month of the Stress Period to the 
start of the Stress Period for both interest rate scenarios. Divide 
the total capital for a given month by the cumulative discount 
factor for that month.
6. Identify the Stress Test capital subtotal, which is the lowest 
discounted total capital amount from among the 240 monthly 
discounted total capital amounts.
7. From the Stress Test capital subtotal, subtract the capital 
required for off-balance sheet items not explicitly modeled in the 
Stress Test, as calculated

[[Page 47874]]

in section 3.9.3.1, Off-Balance Sheet Items, of this Appendix. Then 
subtract the resulting difference from the Enterprise's total 
capital at the start of the Stress Period. The resulting number is 
the amount of total capital that an Enterprise must hold at the 
start of the Stress Test in order to maintain positive total capital 
throughout the ten-year Stress Period.
8. Multiply the minimum total capital amount by 1.3 for management 
and operations risk.

3.12.4  Risk-Based Capital Requirement Output

    The output of the calculations in this section is the risk-based 
capital requirement for an Enterprise at the start date of the 
Stress Test.

4.0  Glossary

    This glossary is intended to define terms in the Regulatory 
Appendix that are used in a computationally specific sense that 
require a precise quantitative definition.

A

    Accounting Flows: one or more series of numbers tracking various 
components of the accounting computations over time, analogous to 
``Cash Flows.''
    Age: of a Mortgage Loan, for computational purpose: the number 
of scheduled payment dates that have occurred prior to the time at 
which the Age is determined. The Age of a newly originated Mortgage 
is zero prior to its first payment date.
    Amortization Expense: used in the accounting sense of the 
monthly allocation of a one-time amount (positive or negative) over 
time, not to describe amortization of principal in a mortgage.
    Amortization Schedule: for a Mortgage Loan, a series of numbers 
specifying the (1) principal and (2) interest components of each 
Mortgage Payment, and (3) the Unpaid Principal Balance after each 
such payment is made.
    Allocated Interest: in certain accounting calculations, the 
amount of interest deemed to be received on a certain date according 
to an allocation formula, whether or not equal to the amount 
actually received on that date (see, e.g., section 3.6.3.8.3, Whole 
Loan Accounting Flows Procedures, of this Appendix).
    Aggregate Limit: see section 3.6.3.6.4.1, Mortgage Credit 
Enhancement Overview, of this Appendix.

B

    Balance Limit: see section 3.6.3.6.4.1, Mortgage Credit 
Enhancement Overview, of this Appendix.
    Balloon Payment: the final payment of a Balloon Loan, the 
principal component of which is the entire Unpaid Principal Balance 
of said loan at the time the Balloon Payment is contractually due.
    Balloon Loan: a Mortgage Loan that matures before the Unpaid 
Principal Balance is fully amortized to zero, thus requiring a large 
final Balloon Payment.
    Balloon Date: the maturity date of a Balloon Loan.
    Benchmark: used as an adjective to refer to the economic 
environment (including interest rates, house prices, and vacancy and 
rental rates) that prevailed in the region and time period of the 
Benchmark Loss Experience.
    Benchmark Census Division: the Census Division, designated by 
OFHEO, that is used to determine house prices and vacancy and rental 
rates of the Stress Period.
    Benchmark Loss Experience (BLE): 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.
    Burnout: in describing Mortgage Prepayments, the reduced rates 
of Prepayment observed with Mortgage Loans that were not prepaid 
during earlier periods when it would have been advantageous to do 
so.

C

    Cash Flow Hedges: cash flow hedges as defined by FAS 133.
    Census Division: any one of the nine geographic areas of the 
United States so designated by the Bureau of the Census. The OFHEO 
House Price Index determined at the Census Division level is used in 
the Stress Test.
    Claim Amount: the amount of Credit Enhancement that an 
Enterprise is eligible to receive as a reimbursement on mortgage 
loan losses, which is often but not always equal to the total amount 
of the loss.
    Commitment Loan Groups: hypothetical groups of Mortgage Loans 
assumed to be originated during the months immediately after the 
start of the Stress Test pursuant to Commitments made but not yet 
fulfilled by the Enterprises prior to the start of the Stress Test 
to purchase or securitize loans.
    Contract: a Mortgage Credit Enhancement contract covering a 
distinct set of loans with a distinct set of contractual terms.
    Constant Maturity Treasury (CMT) Rate: see table 3-18, Interest 
Rate and Index Inputs.
    Counterparty Type: classification used to specify the 
appropriate Haircut level in section 3.5, Counterparty Defaults, of 
this Appendix.
    Credit Enhancement: for the GSEs, agreements with lenders or 
third-parties put in place to reduce or limit mortgage credit 
(default) losses for an individual loan. See section 3.1.2.1.1, Loan 
Group Inputs, of this Appendix.

D

    Debt Service Coverage Ratio: see section 3.6.3.5.3.1, 
Explanatory Variables, of this Appendix.
    Default: for purposes of computing rates of mortgage default and 
losses, see the specific process specified in section 3.6.1, Whole 
Loan Cash Flows Overview, of this Appendix.
    Defaulting Fraction: in any month, for any group of loans, the 
proportion of loans newly defaulted in that month expressed as a 
fraction of the initial loans (by number or by balance, depending on 
how Prepayment and Default Rates are measured) in the loan group; 
see, e.g., section 3.6.3.4.3.2, Prepayment and Default Rates and 
Performance Fractions, of this Appendix.
    Defaulted UPB: the Unpaid Principal Balance (UPB) of a loan in 
the month that it Defaults.
    Deferred Balances: see section 3.6.3.8.1, Whole Loan Accounting 
Flows Overview, of this Appendix.
    Derivative Mortgage Security: generally refers to securities 
that receive cash flow with significantly different characteristics 
than the aggregate cash flow from the underlying mortgage loans, 
such as Interest-Only or Principal-Only Stripped MBSs or REMIC 
Residual Interests. See section 3.7.1, Mortgage-Related Securities 
Overview, of this Appendix.
    Deposit Limit: see section 3.6.3.6.4.1, Mortgage Credit 
Enhancement Overview, of this Appendix.
    Distinct Credit Combination (DCC): see section 3.6.3.6.4.1, 
Mortgage Credit Enhancement Overview, of this Appendix.

E

    Enterprise Cost of Funds: for any maturity, the Federal Agency 
Cost of Funds (see section 3.3, Interest Rates, of this Appendix).
    Enterprise Loss Position: see section 3.6.3.6.4.1, Mortgage 
Credit Enhancement Overview, of this Appendix.

F

    Fair Value Hedges: fair value hedges as described in FAS 133.
    Float Income: 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. See section 3.6.1, Whole Loan 
Cash Flows Overview, of this Appendix.

G

    Gross Loss Severity: Loss Severity including the excess, if any, 
of Defaulted UPB over gross sale price of an REO property, fees, 
expenses and certain unpaid interest amounts, before giving effect 
to Credit Enhancement or any other amounts received on account of a 
defaulted loan (all such amounts expressed as a fraction of 
Defaulted UPB); see 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.
    Guarantee Fee: the amount received by an Enterprise as payment 
for guaranteeing a mortgage loan; see, e.g., section 3.6.3.2, 
Payment Allocation Conventions, of this Appendix.

H

    Haircut: the amount by which payments from a counterparty are 
reduced to account for a given probability of counterparty failure.

I

    Initial: used as an adjective to specify conditions at the start 
of the Stress Test, except in defined terms; see also Time Zero.
    Initial Rate Period: for an Adjustable Rate Mortgage, the number 
of months before the

[[Page 47875]]

mortgage interest rate changes for the first time. Also known as 
``teaser period.''
    Interest-only Period: for interest-only loans, the period of 
time for which the monthly payment covers only the interest due. 
(During the interest-only period, the UPB of the loan stays constant 
until maturity or a changeover date. For loans that mature, a 
Balloon Payment in the amount of the UPB is due at maturity. In 
other cases, the loan payment is recast at the changeover date and 
the loan begins to amortize over its remaining term.) See section 
3.6.3.3.1, Mortgage Amortization Schedule Overview, of this 
Appendix.
    Interest Rates: the Constant Maturity Treasury yields and other 
interest rates and indexes used in the Stress Test.
    Investor-owned: a property that is not owner-occupied.

L

    Loan Limit: used to describe a type of Credit Enhancement; see 
section 3.6.3.6.4.1, Mortgage Credit Enhancement Overview, of this 
Appendix.
    Loan Group: a group of one or more mortgage loans with similar 
characteristics, that are treated identically for computational 
purposes in the Risk-Based Capital calculations.
    Loss Severity: the amount of a mortgage loss divided by the 
Defaulted UPB.
    Loss Sharing Arrangements (LSA): see section 3.6.3.6.4.1, 
Mortgage Credit Enhancement Overview, of this Appendix.

M

    Maximum Haircut: as defined in section 3.5, Counterparty 
Defaults, of this Appendix.
    Modified Pool Insurance: a form of Single Family Mortgage Credit 
Enhancement described in section 3.6.3.6.4.1, Mortgage Credit 
Enhancement Overview, of this Appendix.
    Mortgage Insurance (Primary Mortgage Insurance): a type of 
credit enhancement that pays claims up to a given limit on each 
loan. See section 3.6.3.6.4.1, Mortgage Credit Enhancement Overview, 
of this Appendix.
    Mortgage Related Security: a collective reference for (1) 
securities directly backed by mortgage loans, such as Single Class 
MBSs, Multi-Class MBSs (REMICs or Collaterilized Mortgage 
Obligations (CMOs)); (2) Derivative Mortgage-Backed Securities 
(certain multi-class and strip securities) issued by Fannie Mae, 
Freddie Mac, and Ginnie Mae; (3) Mortgage Revenue Bonds issued by 
State and local governments and their instrumentalities; or (4) 
single class and Derivative Mortgage-Backed Securities issued by 
private entities. See section 3.1.2.2, Mortgage-Related Securities 
Inputs, of this Appendix.

N

    Negative Amortization: as defined in section 3.6.3.2.1, 
Allocation of Mortgage Interest, of this Appendix.
    Net Loss Severity: Gross Loss Severity reduced by Credit 
Enhancements and any other amounts received on account of a 
defaulted loan (all such amounts expressed as a fraction of 
Defaulted UPB).
    Net Yield Rate: the Mortgage Interest Rate minus the Servicing 
Fee Rate.
    New Activity: as defined in section 3.11, Treatment of New 
Enterprise Activities, of this Appendix.
    Notional Amount: the amount analogous to a principal balance 
which is used to calculate interest payments in certain swap 
transactions or derivative securities.

O

    Original: used as an adjective to specify values in effect at 
Loan Origination.
    Origination: for a Mortgage Loan with monthly payments, the date 
one month prior to the first contractual payment date.
    Owner-Occupied: a property, or a Mortgage Loan backed by a 
property, that is a single family residence which is the primary 
residence of the owner.

P

    Pass-Through Rate: the Mortgage Interest Rate minus the 
Servicing Fee and the Guarantee Fee.
    Performing Fraction: in any month, for any group of loans, the 
proportion of loans that have not either prepaid or defaulted in 
that month or any prior month, expressed as a fraction of the loans 
at the start of the Stress Test (by number or by balance, depending 
on how Prepayment and Default rates are measured) in a loan group; 
see e.g., section 3.6.3.4.3.2, Prepayment and Default Rates and 
Performance Fractions, of this Appendix.
    Prepaying Fraction: in any month, for any group of loans, the 
proportion of loans that prepay in full in that month expressed as a 
fraction of the loans at the start of the Stress Test (by number or 
by balance, depending on how Prepayment and Default rates are 
measured) in the loan group; see e.g., section 3.6.3.4.3.2, 
Prepayment and Default Rates and Performance Fractions, of this 
Appendix.
    Prepayment: the prepayment in full of a loan before its 
contractual maturity date
    Prepayment Interest Shortfall: as defined in section 3.6.3.1, 
Timing Conventions, of this Appendix.

R

    Risk-Based Capital (RBC) Report: The form in which Enterprise 
data is to be submitted for purposes of calculating the risk-based 
capital requirement, as described in section 3.1, Data, of this 
Appendix.
    Relative Spread: as defined in section 3.6.3.4.3.1, Single 
Family Default and Prepayment Explanatory Variables, of this 
Appendix.
    Retained Loans: as described in section 3.6.1, Whole Loan Cash 
Flows Overview, of this Appendix.

S

    Scheduled Principal: the amount of principal reduction that 
occurs in a given month according to the Amortization Schedule of a 
mortgage loan; see section 3.6.3.3, Mortgage Amortization Schedule, 
of this Appendix.
    Servicing Fee: portion of mortgage interest payment retained by 
servicer.
    Sold Loans: as described in section 3.6.1, Whole Loan Cash Flows 
Overview, of this Appendix.
    Spread Accounts: a form of Credit Enhancement; section 
3.6.3.6.4, Mortgage Credit Enhancement, of this Appendix.
    Stress Period: the 10-year period covered by the Stress Test 
simulation.
    Stress Test: the calculation, which applies specified economic 
assumptions to Enterprise portfolios, described in this Appendix.
    Strike Rate: the interest rate above/below which interest is 
received for caps/floors.
    Subordination Agreements: a form of Credit Enhancement in which 
the cash flows allocable to a portion of a mortgage pool are used to 
cover losses on loans allocable to another portion of the mortgage 
pool; see section 3.6.3.6.4, Mortgage Credit Enhancement, of this 
Appendix.

T

    Time Zero: used to designate the conditions in effect at the 
start of the Stress Test, as defined in section 3.6.3.1, Timing 
Conventions, of this Appendix.

U

    Unpaid Principal Balance (UPB): the Unpaid Principal Balance of 
a loan or loan group based solely on its Amortization Schedule, 
without giving effect to any missed or otherwise unscheduled 
payments.

W

    Whole Loan: a mortgage loan.

    Dated: July 19, 2001.
Armando Falcon, Jr.,
Director, Office of Federal Housing Enterprise Oversight.
[FR Doc. 01-18459 Filed 9-12-01; 8:45 am]
BILLING CODE 4220-01-U