[Federal Register Volume 66, Number 243 (Tuesday, December 18, 2001)]
[Proposed Rules]
[Pages 65146-65162]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-30898]



Office of Federal Housing Enterprise Oversight

12 CFR Part 1750

RIN 2550-AA23

Risk-Based Capital

AGENCY: Office of Federal Housing Enterprise Oversight, HUD.

ACTION: Proposed regulation.


SUMMARY: The Office of Federal Housing Enterprise Oversight (OFHEO) is 
proposing to amend Appendix A to Subpart B of 12 CFR Part 1750 Risk-
Based Capital. The effect of these amendments would be to modify 
provisions relating to counterparty haircuts, multifamily loans, and 
refunding and to make several technical

[[Page 65147]]

adjustments and corrections. These amendments are intended to refine 
the stress test model to tie capital more closely to risk.

DATES: Written comments must be received by January 17, 2002.

ADDRESSES: Send written comments concerning the proposal to Alfred 
Pollard, General Counsel, Office of Federal Housing Enterprise 
Oversight, Fourth Floor, 1700 G Street, NW., Washington, DC 20552. 
Written comments may also be sent to Mr. Pollard by electronic mail at 
[email protected]. OFHEO requests that written comments submitted 
in hard copy also be accompanied by the electronic version in MS Word 
or in portable document format (PDF) on 3.5" disk.

Associate Director, Office of Risk Analysis and Model Development, 
telephone (202) 414-3763 (not a toll-free number), or David Felt, 
Associate General Counsel, telephone (202) 414-3750 (not a toll-free 
number), Office of Federal Housing Enterprise Oversight, Fourth Floor, 
1700 G Street, NW., Washington, DC 20552. The telephone number for the 
Telecommunications Device for the Deaf is (800) 877-8339.



    The Office of Federal Housing Enterprise Oversight (OFHEO) invites 
comments on the proposed regulation and will take all comments into 
consideration before issuing the final regulation. Copies of all 
comments will be posted on the OFHEO internet web site at http://www.ofheo.gov. In addition, copies of all comments received will be 
available for examination by the public at the Office of Federal 
Housing Enterprise Oversight, Fourth Floor, 1700 G Street, NW., 
Washington, DC 20552.


    On September 13, 2001, OFHEO published a final regulation setting 
forth a risk-based capital stress test, (Rule) \1\ that is the basis 
for determining the risk-based capital requirement for the Federally 
sponsored housing enterprises--Federal National Mortgage Association 
(Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) 
(collectively, the Enterprises). The risk-based capital stress test set 
forth in the Rule simulates the performance of each Enterprise's 
assets, liabilities, and off-balance-sheet obligations under severe 
credit and interest rate stress for a period of ten years (stress 
period). The stress test projects rates of default and prepayment for 
the mortgages guaranteed by the Enterprises, as well as cash flows from 
these and other assets, liabilities, and off-balance-sheet obligations. 
Using these cash flows, the stress test produces monthly balance sheets 
for the 120 months of the stress period in order to determine the 
amount of starting capital that would be necessary to maintain positive 
capital during the ten-year stress period. Thirty percent of the amount 
of capital so determined is then added to that amount to protect 
against management and operations risk.

    \1\ Risk-based Capital, 66 FR 47730 (September 13, 2001).

    OFHEO continuously seeks to improve its measurements and formulas 
to tie capital more closely to risk and works to ensure that the Rule 
supports the safety and soundness regime created by Congress. In the 
preamble to the Rule, OFHEO expressed its intention to review, on an 
ongoing basis, the operation of the stress test and its various 
components and to evaluate the need for revisions and improvements. 
Also, OFHEO committed to act expeditiously to remedy any technical and 
operational issues that arise during the one-year implementation period 
following promulgation. OFHEO is now proposing to make refinements and 
technical adjustments and corrections to the Rule to tie capital more 
closely to risk. Technical changes are included in this proposal rather 
than issued as a final regulation to provide a comprehensive package of 

A. Proposed Changes to Counterparty Haircuts

    The Rule gives the Enterprises credit for cash payments that would 
be received during the stress period from securities and various 
counterparties, such as mortgage insurance companies and derivative 
counterparties. However, because Enterprise counterparties are 
themselves likely to be adversely affected by the economic conditions 
of the stress period and to default on some or all of their 
obligations, the stress test discounts the value of cash payments 
received during the stress period by a specified percentage, based on 
the public credit rating of the security or counterparty. The amount by 
which cash payments from a counterparty or security are discounted in 
each month of the stress period is the haircut. The specified haircut 
percentages increase as the credit rating declines--the lower that 
rating, the more severe the haircut. In the Rule, the haircuts are 
phased in over the first five years of the stress period, except for 
haircuts for below-investment-grade providers and instruments, which 
are applied fully in the first month of the stress period.
    The Rule applies one set of haircuts for non-derivative 
counterparties and securities, based on analysis of historical bond 
default rates, and a different set of haircuts for derivative 
counterparties, reflecting lower expected loss severities associated 
with the use of strong collateral agreements. To further refine the 
Rule's treatment of haircuts, OFHEO proposes to improve consistency 
between haircuts for derivative counterparties and securities and non-
derivative counterparties and securities by specifying default and 
severity rates separately; to extend the phase-in period from five to 
ten years; to provide for netting of exposures to the same derivative 
counterparty; and to provide for an exception to the BBB haircut for 
certain unrated seller/servicers as described in the proposed rule.
    Default Rates. OFHEO proposes to use the Rule's haircut rates for 
non-derivative counterparties and securities as the cumulative default 
rates for all counterparties and securities, but to lower slightly the 
default rate for AA-rated firms. After re-evaluating the historical 
data on differences in performance of AA-rated and AAA-rated firms, 
including data that recently has become available to OFHEO, the Rule's 
default ratio of three to one (based largely on the average exposure 
over the past 80 years) appears to be more than is warranted for a 
period of economic stress. Data were recently made available to OFHEO 
by Moody's Investors Service \2\ for the worst annual cohorts of U.S. 
investment-grade issuers since 1920, the cohorts formed at the 
beginning of 1929, 1930, and 1931. The average 10-year default rate for 
AA-rated issuers (12.25 percent) was 2.6 times as large as the average 
default rate for AAA-rated issuers (4.72 percent), and the ratio for 
the worst of those years was only 2.2. Furthermore, a study of 
corporate bond quality by W. Braddock Hickman shows 12-year default 
rates for the cohort formed at the beginning of 1928 for AA-rated 
issuers (12.3 percent) to be 1.5 times as large as that for AAA-rated 
issuers (8.1 percent).\3\ More recent data, in relatively favorable 

[[Page 65148]]

circumstances, also show greater similarity in the performance of 
issuers in these two rating categories. However, a partially offsetting 
factor is that Moody's data for both depression cohorts and averages of 
all cohorts show that defaults of AAA-rated issuers that occur within 
10 years after the cohort is formed occur later in the 10-year period 
than those of AA-rated issuers.

    \2\ For purposes of this proposal, Moody's Investors Service 
provided information on ``Letter Cumulative Default Rates (from 01/
01/29 to 01/01/31)'' on October 16, 2001. Data may be obtained from 
Moody's Investors Service by contacting Mr. Steve Liebling at 
[email protected]'s.com.
    \3\ W. Braddock Hickman, ``Corporate Bond Quality and Investor 
Experience,'' 190 National Bureau of Economic Research (1958).

    The relationship between AA and AAA defaults is particularly 
relevant because most Enterprise counterparty and security exposures 
are either AAA-or AA-rated. An excessive differential between these 
ratings in the stress test could create inappropriate business 
incentives for the Enterprises. After weighing the above 
considerations, OFHEO proposes to lower the cumulative default rate for 
AA-rated counterparties and securities to 12.5 percent (from 15 
percent), which will be 2.5 times the rate for AAA-rated counterparties 
and securities.
    Severity Rates. To further refine risk measurement in the stress 
test, OFHEO proposes to take explicit account of potential recoveries 
in the event of default by introducing a loss severity factor. Before 
issuing the Rule, OFHEO received mixed comments regarding incorporation 
of recovery projections for non-derivative security and counterparty 
obligations after default. Such recoveries were not part of the 
proposed rule, however, and OFHEO decided not to include them at that 
time, pending further consideration. Historically, corporate bond 
recoveries have averaged about 40 percent (i.e., a 60 percent loss 
severity rate) over long periods of time. A study of default and 
recovery rates by Moody's shows an average recovery rate of 39 percent 
over the past 20 years.\4\ A study of defaulted bond recoveries by 
Standard and Poor's shows an average recovery rate of 44 percent from 
1981 to 1997.\5\ The Hickman study shows an average recovery rate of 43 
percent for large issues from 1900 to 1943.\6\ Recoveries on Enterprise 
holdings of mortgage and other asset-backed securities and on mortgage 
insurance claims would likely be substantial also, benefiting from 
asset values in the former case and premium income in the latter.

    \4\ ``Default Recovery Rates of Corporate Bond Issues: 2000,'' 
26 Moody's Investor's Service (February 2001).
    \5\ ``Ratings Performance 1997: Stability of Transition,'' 3 
Standard and Poor's (August 1998).
    \6\ Hickman, at 460.

    Data on recoveries in unusually stressful times are less favorable. 
Hickman reported an average recovery rate of 34 percent for large 
issues for defaults in 1930 to 1943.\7\ Moody's has reported average 
recovery rate estimates that are substantially lower during recessions, 
and fall as low as 20 percent during the 1930s.\8\ For 1930 to 1943, 
Moody's average was 36 percent, despite higher rates during the latter 
years of that period. A somewhat lower projection for the stress period 
used in the rule is, therefore, appropriate.

    \7\ Hickman, at 119.
    \8\ ``Historical Default Rates of Corporate Bond Issuers, 1920-
1996,'' 12 Moody's Investor Service (January 1997).

    All of the recovery studies show some differences in recovery rates 
depending on the presence or absence of secured or subordinated status. 
However, such status is a factor used in determining ratings. Moody's 
expressly states that securities with different status may have similar 
probabilities of default, but be rated differently in recognition of 
the effect of security or subordination on likely recoveries.\9\ Thus, 
a secured instrument may have a somewhat higher probability of default 
than average for its rating, but also have a somewhat higher 
expectation of recovery. Accordingly, OFHEO proposes to specify a 
recovery rate of 30 percent (70 percent loss severity rate) for all 
non-derivative counterparties and securities with investment-grade 

    \9\ Moody's (2001), at 24-25.

    OFHEO also proposes to maintain, with alteration, special treatment 
for derivative counterparty exposures. Current exposures are marked to 
market at least weekly, and high quality collateral is posted against 
any significant exposures by counterparties with less than a AAA 
rating. The Enterprises retain the right to require substantial over-
collateralization or to transfer the contract to a new counterparty if 
a counterparty's rating is lowered to low investment-grade levels or 
worse. Thus, the principal risk is that a relatively highly rated 
counterparty may fail suddenly and that exposures rise between the time 
a contract was last collateralized and the time the Enterprise takes 
action to transfer or replace the contract. This period may be as much 
as ten business days.
    The credit exposures on fixed-floating interest rate swaps and 
swaptions (the vast majority of Enterprise derivative contracts) are 
closely tied to changes in market yields of securities with maturities 
equal to those of the swap or swaptions. When interest rates rise, an 
Enterprise's exposure rises on swaps for which it receives the 
floating-rate side of the swap. When interest rates fall, an 
Enterprises's exposure rises on swaps for which it receives the fixed-
rate side.
    To develop loss severity rates for defaulted derivative contracts, 
OFHEO examined changes in Treasury security interest rates over periods 
of ten business days during the past 25 years. For five-year Treasury 
securities, increases in yields of more than 7.5 percent and decreases 
of more than 5.0 percent, respectively, have occurred infrequently-
roughly 1 percent and 4 percent, respectively, of the time.\10\ Thus, 
severity rates that reflect losses associated with yield changes of 
these magnitudes should be reasonably conservative.

    \10\ These percentages correspond to absolute changes of 61 and 
41 basis points, on average, during the period, but would be less 
than half as much at recent yield levels.

    For application in the stress test's cash flow model, OFHEO must 
translate such changes into impacts on net derivative cash flows. 
During the stress period, net derivative cash flows are related to 
changes in the ten-year Treasury yield-75 percent in the up-rate 
scenario and 50 percent in the down-rate scenario. For example, in the 
up-rate scenario, with its flat yield curve, the pay side of a ten-year 
pay-fixed/receive-floating swap implemented just before the start of 
the stress test would remain at its original rate and the receive side 
would rise to 175 percent of the original pay-side rate. Thus, the swap 
would have net annual cash flows for the last nine years of the stress 
test roughly equal to 75 percent of the initial fixed rate used in the 
swap multiplied by the notional value. This is ten times the 7.5 
percent market yield change that may be associated with losses on a 
derivative counterparty default in the up-rate scenario. Accordingly, 
OFHEO proposes to set severity rates for derivative exposures at ten 

    \11\ Loss severities of counterparty defaults are typically 
expressed as percentages of derivative market value at the time of 
default. However, the stress test model reflects such losses as 
reductions in net derivative cash flows. For example, in the up-rate 
stress scenario, after a 75 percent increase in interest rates, a 
swap with a market value of zero at the start of the stress test 
(i.e., a fixed-pay rate equal to the then-market rate) will have a 
significantly increased market value during the stress period. Since 
short- and long-term rates are the same in the last nine years of 
the stress period in the up-rate scenario, net derivative cash flows 
roughly equal the scenario-based change in long-term interest rates 
multiplied by the notional value, and the market value of the swap 
is the discounted present value of these cash flows. A ten percent 
reduction in those cash flows thus reflects the impact on market 
value of a 7.5 percent change in interest rates.

    OFHEO recognizes that losses could be greater than ten percent if 
interest rates move exceptionally after a sudden default, or if an 
Enterprise failed to replace a contract with a defaulting counterparty 
and market yields

[[Page 65149]]

continued to move unfavorably. However, OFHEO also recognizes that 
yield changes near the time of a default could easily be less 
unfavorable than the 7.5 percent increase or 5 percent decrease 
contemplated, and some recoveries beyond the collateral already held 
might be available. Thus, OFHEO judges that a ten percent severity rate 
for derivatives is adequate.
    Haircuts. Under the proposal, haircuts would be determined by 
multiplying the default rate for each rating category by the severity 
rate. The resulting haircuts that are proposed are set forth in Table 1 

         Table 1--Stress Test Haircut by Ratings Classification
                                            Derivative       Contract
         Ratings Classification              Contract     Counterparties
                                          Counterparties  or Instruments
Cash                                                  0%              0%
AAA                                                 0.5%            3.5%
AA                                                 1.25%           8.75%
A                                                     2%             14%
BBB                                                   4%             28%
Below BBB and Unrated                               100%            100%

    Phase-In. Under the Rule, haircuts for investment-grade 
counterparties and securities are phased-in over the first five years 
of the stress period, so that haircuts are close to zero in the first 
month of the stress period and rise to their maximums in the 60th 
month, where they remain for the last five years. In effect, all 
defaults occur within the first five years, and later haircuts to cash 
flows simply reflect the consequences of previous defaults, as 
defaulted counterparties are unable to meet their obligations. This 
conservative approach takes into account that the interest rate shocks 
and house price shocks all occur in the first half of the stress 
period. Long-term average historical data show more evenly distributed 
defaults over time, but available data for especially stressful periods 
(e.g., the 1910s and 1930s) give little indication of timing. The 
recently obtained unpublished data from Moody's shows that for the 
worst cohort (starting in the beginning of 1930), only 57 percent of 
ten-year investment-grade defaults occurred during the first five 
years. While the principal shocks may occur somewhat earlier in the 
stress period than they did for issuers in the 1930s, a closer 
approximation of the historical patterns may better reflect the ability 
of most highly rated firms to survive severe stresses for many years. 
Some of those that ultimately fail during the stress period may 
reasonably be expected to fail during its final years. Accordingly, 
OFHEO proposes to extend the phase-in period from five years to ten 
years for investment-grade counterparties and securities. Thus, for 
credit exposures to firms and securities rated BBB and higher, defaults 
will occur evenly throughout the stress period.
    Netting of derivative counterparty exposures. The Enterprises 
regularly enter into derivatives contracts, typically swaps, for debt 
and portfolio risk management purposes. These contracts expose the 
Enterprises to the risk of failure by a derivative counterparty to 
perform its obligations as anticipated by the terms of the contract. 
The Enterprises, consistent with accepted risk management and market 
practice, attempt to mitigate their derivative counterparty credit 
exposure through a number of methods, including the use of master 
netting agreements. Master netting agreements are used by the 
Enterprises when they engage in multiple swap transactions with the 
same counterparty. A master netting agreement permits an Enterprise to 
determine its aggregate total credit exposure to a particular 
counterparty by netting the gains and losses across all of the 
contracts with that counterparty. This approach allows the Enterprises 
to net their exposures at the counterparty level, rather than netting 
at the individual contract level.
    In NPR2, OFHEO proposed a methodology to recognize this practice by 
modeling the terms of master netting agreements and then applying 
specified haircuts to the resulting net amount due, if any, from each 
derivatives counterparty.\12\ No comments were received on the 
proposal, and the Rule, reflecting OFHEO's intent to model master 
netting agreements, did not specify a change from NPR2. However, due to 
a technical omission, OFHEO's intent to model master netting agreements 
was not operationalized in the Rule. Recognition of master netting 
agreements would result in a more accurate measurement of the 
Enterprises' exposure to derivative counterparties. Further, 
recognition of master netting agreements is consistent with OFHEO's 
intent to model Enterprise contracts according to their respective 
terms, and such recognition allows OFHEO to tie capital to risk with 
greater precision. The proposal would amend the Rule to model master 
netting agreements explicitly, as originally contemplated in NPR2.

    \12\ NPR2 refers to the Second Notice of Proposed Rulemaking 
issued by OFHEO before the Rule. 64 FR 18084, 18159 (April 13, 

    OFHEO notes that this technical correction will require an 
implementation period to allow for development and completion of the 
software changes that will allow OFHEO to model master netting 
agreements. Therefore, during the implementation of the technical 
correction, OFHEO will recognize the risk mitigation effects of such 
agreements by reducing the haircuts for derivatives contracts. Upon 
implementation of the technical correction, maximum haircuts for 
derivative contract counterparties will be readjusted and netting by 
counterparty will be implemented in the software. The interim treatment 
will remain effective only for the period

[[Page 65150]]

required to complete the technical software modifications necessary to 
model master netting agreements. The interim and final haircuts for 
derivative contract counterparties are as shown in the Table 2 below:

  Table 2--Stress Test Haircuts for Derivative Contract Counterparties
                           Haircuts for    Haircuts for
                            Derivative      Derivative
                          Counterparties  Counterparties     Number of
 Ratings Classification      prior to          upon          Phase-in
                          Implementation  Implementation      Months
                            of Netting      of Netting
Cash                                  0%              0%             N/A
AAA                                 0.3%            0.5%             120
AA                                 0.75%           1.25%             120
A                                   1.2%            2.0%             120
BBB                                 2.4%            4.0%             120
Below BBB and Unrated               100%           100%1

    Unrated Seller/servicers. The Rule treats unrated seller/servicers 
as BBB-rated counterparties. OFHEO recognizes that certain unrated 
seller-servicers to whom underwriting and servicing authority has been 
delegated enter into loss-sharing agreements with the Enterprises and 
collateralize these loss-sharing obligations with fully funded reserve 
accounts pledged to the Enterprise. OFHEO is proposing to amend the 
Rule to permit a higher rating than BBB for these seller-servicers if 
the fully funded reserve account is equal to or greater than an amount 
determined by OFHEO to be adequate to support the risk borne by the 
seller-servicer under the loss sharing agreement. For example, if the 
loss-sharing obligation of a seller-servicer participating in Fannie 
Mae's Delegated Underwriting and Servicing (DUS) Program is 
collateralized by a fully funded reserve account that is equal to or 
greater than one percent of the seller-servicer's aggregate unpaid 
principal balance covered by the loss-sharing agreement at the start of 
the stress test, the rating of the issuer of the instrument backing the 
reserve account may be used, in lieu of BBB, as the rating of the 
unrated seller-servicer, except that in no event will the rating exceed 
AA. Determinations of the required reserve amount and the rating 
permitted would be made on a program-by-program and Enterprise-by-
Enterprise basis.

B. Proposed Changes to Multifamily Model

    OFHEO is proposing a number of changes to the multifamily default 
model, multifamily loss severity parameters, and multifamily prepayment 
speeds specified in the Rule. Proposed changes to the default model 
include (1) a respecification of explanatory variables which has the 
effects of reducing the model's sensitivity to debt-service coverage 
ratios (DCRs) falling below one and reducing predicted cumulative 
default rates on adjustable rate mortgages (ARMs) in the up-rate stress 
test, and (2) an increase to the initial vacancy rate used to update 
DCR during the stress test making this rate consistent with the 
benchmark region's vacancy rate from the month prior to the start of 
the benchmark period.\13\ OFHEO is also proposing changes for the 
multifamily loss severity parameters that reflect the costs, timing, 
and recoveries associated with a larger and more broad-based set of 
Enterprise foreclosures. The Rule reflects a decision not to model the 
complexities of prepayment premiums that may or may not be received by 
the Enterprises during stressful periods without further study. The 
proposed multifamily prepayment speeds are more consistent with that 
decision than existing pre-payment speeds. Each proposed change is 
discussed in turn.

    \13\ The terms ``benchmark region and period'' refer to the 
regional credit loss experience identified by OFHEO in compliance 
with the ``Credit Loss'' parameters outlined in 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), as described in additional detail 
in NPR2.

    Underwater Debt Coverage Ratio flag (UWDCRF). In the Rule, the 
multifamily default model included an Underwater Debt Coverage Ratio 
Flag (UWDCRF), intended to cover the additional default risk posed when 
the projected debt service coverage ratio-net operating income (NOI) 
divided by mortgage payment-falls below one during the stress test. A 
debt coverage ratio less than one means that the NOI is insufficient to 
cover the required mortgage payment, an occurrence that suggests a high 
probability of default. The stress test projects the DCR in each month 
of the stress period from the prior month's value by updating NOI, 
using rent growth rates and rental vacancy rates that reflect the 
economic conditions of the benchmark region and period, and adjusting 
mortgage payments monthly according to the note terms and the stress 
test interest rate scenario. When this method is used to project DCR, 
the types of loans for which the projected DCR falls below one tend to 
be fixed rate mortgages (FRMs) that started the stress test with a low 
DCR and, in the up-rate scenario, most ARM loans, resulting in 
comparatively high cumulative default rates for these loans in the 
stress test.
    OFHEO has found that the UWDCRF adds value to the multifamily 
default model by capturing the additional risk of default when NOI is 
insufficient to cover mortgage payments, but is concerned that the 
sensitivity of predicted monthly defaults to projected DCR falling 
below one may be too great, for two reasons. First, the UWDCRF is an 
indicator that is only turned on when DCR is projected to be below one, 
and is turned off otherwise. There are no finer gradations for this 
explanatory variable such as those that might be captured if the 
projected DCR accounted for individual property dispersion around the 
mean.\14\ In the application of

[[Page 65151]]

the stress test, many multifamily loan groups will have DCRs projected 
to fall below one--some only slightly below one, while others fall well 
below one. The additional risk of default may be overstated for those 
loan groups with DCRs projected to fall only slightly below one by the 
abrupt transition of the UWDCRF variable. Second, even when a 
multifamily property's DCR does fall below one, only a fraction of 
borrowers default, indicating that those who do not default may carry 
their properties with funds from other sources for a period of time 
while they try to remedy the negative cash flow position.

    \14\ In the Rule's single-family default and prepayment models, 
the level of borrower equity in the property (property value less 
mortgage debt) is analogous to multifamily DCR in that both measures 
capture economic stress. The circumstance of a single-family 
mortgage borrower having negative equity is similar to that of a 
multifamily loan having a DCR below one because both are associated 
with increased likelihood of default. However, in the single-family 
model, negative equity is captured as a probability and enters the 
model as categorical variable having eight possible values. These 
eight gradations for the probability of negative equity improve the 
single-family model by avoiding abrupt predicted transitions from 
positive to negative equity. OFHEO is able to calculate the 
probability of negative equity for single-family loans because 
projected property value changes are based on OFHEO's House Price 
Index and its associated dispersion parameters. No similar measures 
of dispersion are currently available to project multifamily DCR or 
the probability of DCR falling below one.

    For these reasons, OFHEO decided to re-estimate the multifamily 
default model with a revised definition of the UWDCRF that turns the 
flag on only when the DCR is projected to be well below one. As a 
result of that re-estimation, OFHEO proposes to redefine the UWDCRF to 
be equal to one (that is, to turn the flag on) when projected DCR is 
less than 0.98 (that is, when NOI is more than two percentage points 
below the mortgage payment), rather than setting the flag equal to one 
immediately when the projected DCR falls below one. The re-estimated 
multifamily default model has a slightly lower coefficient on UWDCR, 
and the coefficients for the other explanatory variables do not change 
materially. Simulations using the revised UWDCRF definition result in 
lower predicted default rates for ARMs in the up-rate scenario and for 
FRMs with low initial DCR in both scenarios, making the model less 
sensitive to the UWDCRF than the existing model. The revised definition 
does not substantially affect the predicted default rates for most FRMs 
or for ARMs in the down-rate scenario. OFHEO believes the respecified 
model more accurately captures the added risks associated with loans 
that have negative cash flow in the stress test.
    ARM Flags. OFHEO is concerned that predicted cumulative default 
rates for ARM loans are excessive in the up-rate scenario. For example, 
a typical ARM purchased by an Enterprise could have a cumulative 
default rate of 95 percent in the up-rate scenario. These excessive 
default rates for ARMs in the up-rate stress test arise from two 
principal sources. First, the up-rate stress test projects declining 
DCRs for ARMs, and two explanatory variables in the default model 
translate declining DCRs into higher default rates: the DCR variable, 
itself, and the UWDCRF, where applicable. The second source is from the 
application of an ARM product-type flag--New Book ARM Flag (NAF)--which 
further raises the predicted ARM default rates. OFHEO included the ARM 
product flag in the Rule because it observed in the historical data 
from the Enterprises that ARM defaults appear to be higher than those 
of otherwise comparable FRMs even after controlling for DCR changes due 
to interest rate changes.
    The stress test projects DCR in each month of the stress period 
from the prior month's value using rent growth rates and vacancy rates 
that reflect the economic conditions of the benchmark region and period 
along with monthly mortgage payment adjustments according to the note 
terms and the stress test interest rate scenarios. In the up-rate 
scenario, the mortgage payment adjustments on ARMs cause the projected 
DCR to fall much more than that of an otherwise comparable FRM. This 
more rapid decline in DCR causes predicted defaults on ARMs to be 
higher than those of otherwise comparable FRMs, as one would expect, 
because mortgage payments on an ARM may grow to exceed net operating 
income from the property. In addition, the NAF further raises new book 
ARM defaults relative to comparable new book FRMs to capture 
performance differences not related to projected changes in DCR.\15\

    \15\ The Rule includes a New Book ARM flag (NAF) and a New Book 
Balloon flag (NBLF) as product-type offsets to the New Book flag 
(NBF), which is a categorical (or dummy) variable that distinguishes 
between ``Old Book'' loans that were made when the Enterprises first 
entered into the multifamily business (before 1988 for Fannie Mae 
and before 1993 for Freddie Mac) and ``New Book'' loans made under 
their more recent restructured programs. OFHEO's research indicates 
that New Book loans have shown lower defaults than Old Book loans in 
general, although the amount of improvement varies significantly 
among product types. Specifically, New Book fixed-rate balloon loans 
outperformed Old Book fixed-rate balloon loans to a lesser degree 
than their fixed-rate fully amortizing counterparts. ARM loan 
performance differentials were even smaller. These differences are 
reflected in the Rule in the NBLF and NAF offsets to the NBF.

    The theoretical justification for the inclusion of an ARM flag to 
account for performance differences not related to ARM payment changes 
is that ARM borrowers may possess higher credit risk qualities than 
their fixed-rate counterparts. Arguing against the inclusion of an ARM 
flag is the improvement in the Enterprises' multifamily ARM 
underwriting in recent years, which means that, over time, differences 
in risk between loan types due to differences in borrower 
characteristics will disappear. That is, the choice of ARM versus FRM 
in the multifamily mortgage market may be becoming a strategic business 
decision related to professional financial management considerations 
and may, as a result, have a declining relationship to borrower credit 
    OFHEO decided that the excessive predicted default rates for ARM 
loans in the up-rate stress test warranted investigation of the default 
model's specification of ARM product type flags. OFHEO sought to 
determine if a respecification of the model could maintain a reasonable 
relationship to the historical data while producing more reasonable 
results in the stress test. First, the estimation was performed without 
either of the two product type flags, the NAF and the New Book Balloon 
Flag (NBLF). If the only additional risk associated with ARMs relative 
to FRMs resulted from the impact of rate changes on mortgage payments 
and DCR, then this specification for the default model might be 
appropriate. OFHEO found, however, that this model specification caused 
another explanatory variable, the Ratio Update Flag (RUF) to be no 
longer statistically significant. Next, OFHEO re-estimated the model 
without the Ratio Update Flag. The result of the second re-estimation 
produced, as expected, an averaging effect between New Book ARM and FRM 
default rates--that is, the size of the coefficient for New Book loans 
decreased (the coefficient remained negative but had a smaller absolute 
value), reflecting the fact that the NBF was now averaging the product 
type differences that are currently separated out by the product type 
flags in the Rule. This specification also reduced the sensitivity of 
defaults to the distinction between New Book and Old Book loans, 
holding other factors constant, because it no longer distinguished 
between loans for which loan-to-value ratio (LTV) and DCR ratios are 
updated and those for which they are not.\16\

    \16\ This effect is captured in the Rule by the Ratio Update 
Flag (RUF). Specifically, the RUF identifies a subset of New Book 
loans--those for which the loan-to-value ratio (LTV) and debt-
service coverage ratio (DCR) have been calculated or delegated to 
have been calculated by the Enterprises at loan origination or for 
which the LTV and DCR have been recalculated or delegated to have 
been recalculated by the Enterprises at Enterprise acquisition 
according to current underwriting standards. New Book loans for 
which origination and/or acquisition LTV and DCR are unknown cannot 
be considered to be ratio-updated.


[[Page 65152]]

    OFHEO rejected the above model re-specification, which eliminates 
the NAF, the NBLF, and the RUF, because it ignored two important 
factors that OFHEO has observed in Enterprise historical data. First, 
OFHEO considered the evidence of higher Enterprise ARM default rates, 
compared with FRM default rates during historical periods when interest 
rates were flat to declining. Since flat-to-declining interest rates 
lead to stable or lower ARM payments and therefore stable or higher 
DCRs, all else equal, OFHEO suspected that factors unrelated to 
interest-rate-related ARM payment changes (such as borrower credit 
quality) may still be underlying the higher observed ARM default rates. 
Second, OFHEO found substantial differences in observed default rates 
for ratio-updated versus not-ratio-updated loans in Enterprise 
historical data. Ratio-updated loans appear to perform better than 
those that are not, holding other factors constant.
    Therefore, OFHEO proposes to re-specify its multifamily default 
model as follows. The proposed model has the same explanatory variables 
as the model in the Rule, except that NAF, NBLF, and RUF are removed, 
and a respecified flag is introduced that captures both the distinction 
between ARMs and FRMs and the distinction between ratio-updated and 
not-ratio-updated loans. Specifically, the new variable OFHEO is 
proposing in its respecified default model is a Not-Ratio-updated ARM 
Flag (NRAF) which takes a value of one (that is, it is turned on) if a 
loan is both an ARM and not ratio-updated, and zero otherwise. Because 
nearly all of the ARM loans in Enterprise historical data are not 
ratio-updated, but nearly all of the FRMs are ratio-updated, OFHEO 
determined that it is statistically difficult to fully separate these 
effects as measures of historical performance. The proposed model with 
the NRAF variable would apply this new variable coefficient during the 
stress test simulation only to ARM loans that are not ratio-updated, 
capturing the historical performance differences of these ARMs after 
controlling for payment changes. ARM loans that have undergone the 
ratio-update process would not be subject to higher default risk 
imposed by the NRAF, thereby reducing the differential between ARM and 
FRM defaults in the up-rate scenario for those loans.
    OFHEO believes that a similar distinction between ratio-updated 
FRMs and not-ratio-updated FRMs should exist even though there are too 
few not-ratio-updated FRMs in the Enterprises' historical data to 
confirm the hypothesis. As a result, OFHEO proposes to multiply monthly 
conditional default rates for not-ratio-updated FRMs by a factor of 1.2 
times the rates for otherwise comparable ratio-updated FRMs to reflect 
the marginally higher risk expected with those loans.
    OFHEO believes that, given the Enterprise data, the proposal 
handles a very complicated issue fairly and with statistical soundness 
and good judgment. If, in the future, Enterprise data show no 
differences between ARM and FRM risk other than the adverse effect of 
rising interest rates on ARM payments and ARM DCR, OFHEO may revisit 
this issue.
    Initial Vacancy Rate. Estimated rent growth for the first month of 
the stress test is based on the relative change in a rent index from 
immediately prior to the stress test to month one of the stress 
test.\17\ However, the estimated vacancy rate change in the first month 
of the stress test does not look back to the value of the vacancy rate 
immediately prior to the stress test, but rather compares the vacancy 
rate in month one of the stress test with a long-term national 
historical average vacancy rate. To be consistent, the change in 
vacancy rates between the period immediately prior to the stress test 
and month one of the stress test should be based on the change in the 
benchmark region vacancy rate from the month prior to the benchmark 
period to the first month of the benchmark period. OFHEO views this 
change as a technical correction.

    \17\ Specifically, the twelfth root of month over same month 
previous year rent indices minus one.

    Specifically, the vacancy rate change in the Rule in the initial 
month of the stress test is from the Census Bureau's long-term national 
historical average of 6.23 percent to the West South Central (WSC) 
Census division's estimated January, 1984, rate of 13.6 percent, with 
changes thereafter based upon changes in rates through 1993 in that 
region.\18\ This specification has the effect of imposing a greater 
percentage increase in vacancies than appears to have occurred during 
the benchmark loss experience.

    \18\ Reporting of vacancy rate data for Metropolitan Statistical 
Area located in the WSC Census division began in 1986. As a result, 
1984 and 1985 rates were estimated based on national rates using the 
ratio of WSC Census division rates to U.S. rental vacancy rates in 
1986, a factor of 2.3. For 1983, a lower factor of 1.8 is assumed 
because it predates the WSC Census division's recession.

    The proposed change is to set the initial vacancy rate at ten 
percent, which is the estimated WSC Census division vacancy rate in 
1983. Thus, the vacancy rate change in the initial month of the stress 
test would be from ten percent to 13.6 percent.
    Loss Severity. Loss severity parameters in the Rule were based upon 
the experience of 705 Freddie Mac multifamily REO \19\ properties from 
the 1980s. OFHEO has now analyzed data reflecting the costs, timing, 
and recovery rates associated with additional REO that has been made 
available from both Enterprises. Based upon that analysis, OFHEO is 
proposing to modify the multifamily severity parameters to take into 
consideration the performance of Fannie Mae REO in the 1980s and both 
Enterprises' more recent multifamily REO. The multifamily loss severity 
calculations that use the severity parameters in the Rule would not 
change. Specifically, OFHEO proposes reducing net REO holding costs to 
seven percent from 13.33 percent and increasing REO sales proceeds from 
58.88 percent to 63 percent of the unpaid principal balance as of the 
default date. Additionally, OFHEO proposes reducing the time from 
default to foreclosure completion from 18 to 9 months while increasing 
the time from REO acquisition to REO disposition from 13 to 15 months. 
Changing these severity parameters yields a 44 percent ``baseline'' 
severity rate, as compared to the 55 percent ``baseline'' produced by 
the model in the Rule. ``Baseline'' severity is a simple way to compare 
one set of severity parameters with another.\20\

    \19\ REO is real estate owned as a result of loan default.
    \20\ The ``baseline'' consists of a simple adding up of the cost 
components of the rate, without considering discounting, credit 
enhancements, or passthrough interest on sold loans.

    Prepayment Penalties. In the Rule, no credit is given for cash 
flows from prepayment penalties and yield maintenance provisions. 
Nevertheless, the Rule provides that two percent of loans that are 
subject to such penalties or provisions prepay each year of the stress 
test in the down-rate scenario. In the preamble to the Rule, OFHEO 
explained that the data indicated that a small percentage of loans did 
prepay while subject to yield maintenance provisions and that OFHEO had 
no data indicating to what extent prepayment penalties were actually 
paid by borrowers, as opposed to waived by the Enterprises or added to 
the balances of refinanced loans. Because it is likely that some 
prepayment penalties are paid or other compensating consideration is

[[Page 65153]]

received by the Enterprises, OFHEO decided to include some prepayments 
on these loans in the down-rate scenario, but at a lower rate than 
indicated by the data in order to take prepayment penalties into 
    OFHEO is proposing to modify the Rule to provide for no prepayments 
in the down-rate scenario inside prepayment penalty or yield 
maintenance periods. This approach is more consistent with OFHEO's 
preference to model contractual instruments according to their terms, 
but recognizes that modeling these penalties according to their terms 
would be immensely complicated, because those terms vary greatly from 
loan to loan. The proposed approach is a reasonable simplification 
because prepayment penalty provisions are actually liquidated damages 
clauses, which are intended to give the lender the benefit of full 
performance on the loan.

C. Proposed Changes to Yields on Enterprise Debt

    The Rule does not impose a premium upon an Enterprise's cost of 
funds to reflect the reaction of the debt markets to the financial 
stress imposed upon the Enterprise. However, the preamble to the Rule 
suggested that a premium might be appropriate and that this would 
likely be an area of future change. Upon further study, OFHEO has found 
that it is appropriate for the stress test to recognize an increased 
cost of debt of ten basis points for an Enterprise in the stress test 
vis-a-vis other borrowers in the debt markets.
    OFHEO proposed in NPR2 to impose a 50-basis-point premium on new 
Enterprise debt for the last nine years of the stress period. The 
analysis that OFHEO performed for NPR2 indicated that debt spreads to 
Treasury rates have widened in times of financial stress for 
Government-sponsored enterprises (GSEs). NPR2 did not propose 
adjustments to reflect unusual stress for any other interest rate 
series in the stress test.
    In the final rule, OFHEO took note of the comments received in 
response to NPR2, some of which questioned the appropriateness of a 
premium on new Enterprise debt and the size of that premium. OFHEO 
conceded that data upon which to base such a premium may be too sparse 
to determine definitively whether other spreads to Treasuries would 
widen as much as the Enterprises' spreads or to estimate how much the 
Enterprises' spreads would widen. The preamble to the final rule also 
noted that some commenters felt that no premium on new debt should be 
charged because many of the Enterprises' hedging instruments are based 
upon rates other than Treasuries (e.g., LIBOR, COFI). The spreads 
between these rates and Treasuries could be expected to widen during 
stressful conditions, thus mitigating the Enterprises' risk. In light 
of these comments, OFHEO postponed imposition of any new debt premium 
pending later refinements of the Rule. Nevertheless, OFHEO indicated 
that the implicit assumption in the stress test that the spreads of an 
Enterprise's debt yields to other interest rates would be unaffected by 
the deteriorating condition of the Enterprise ignored an area of 
significant risk.
    The risk of wider spreads in a stressful period is important if 
asset lives, which are unusually long in the up-rate scenario, exceed 
terms-to-maturity of outstanding debt. In support of this proposal, 
OFHEO notes that some funding strategies employed by the Enterprises 
depend significantly on their ability to borrow in the future at 
relatively favorable interest rates. For example, the Enterprises often 
fund a portion of their mortgage asset portfolio with short-term debt 
accompanied by interest rate swaps, in which they pay a fixed rate and 
receive a floating rate. If the floating rate they pay on their own 
short-term debt is close to the floating rate they receive on the swap, 
the net effect is roughly the same as if they had issued long-term 
fixed-rate debt at the rate they pay on the swap. If, however, their 
cost of short-term funds rises significantly, relative to the index on 
which the swap's floating rate is based, their cost will be higher than 
if they had issued long-term fixed-rate debt. Use of fixed-pay 
swaptions to hedge against the effect of rising interest rates on 
expected asset lives creates a similar risk. Although the spreads to 
Treasury rates of other interests rates may also widen in a stressful 
economic environment, the stress test is designed to be especially 
stressful to the Enterprises. The stress test involves factors, such as 
a decline in housing prices, that might not affect the debt costs in 
other sectors of the economy as much. OFHEO has chosen to propose a 
ten-basis-point spread for the final nine years of the stress period, 
in part to reflect these risks.
    A ten-basis-point borrowing premium incorporates these risks in a 
modest way. Firms in very stressful circumstances frequently face 
premiums of several hundred basis points, if they are able to borrow at 
all. GSEs, though, have always been able to borrow, even when they are 
in very poor financial condition, because of their perceived special 
status. It is reasonable, therefore, to use a much smaller premium than 
might be appropriate for a non-GSE in a similar stress test. OFHEO also 
considers it appropriate to consider that the stresses affecting the 
Enterprises in the stress test would also be affecting other borrowers 
in the market place. To assume that they do not, as was the case in 
NPR2, which proposed a 50-basis-point premium, is inconsistent with the 
stress implied in the haircuts that the stress test applies to all 
counterparties of the Enterprises. An ideal stress test might model 
different spreads for different interest rate series, a complex 
approach that OFHEO could not implement in the foreseeable future. The 
ten-basis-point premium, therefore, can be viewed as a simplifying 
assumption, which gives some effect to the possibility that stress 
period market conditions could impact an Enterprise more adversely than 
the rest of the market.

D. Proposed Changes to New Debt Mix

    The Rule provides for the funding of all cash deficits by the 
issuance of new long-or short-term debt, whichever is in shorter 
supply, until a 50/50 balance of short-to long-term debt is reached in 
each Enterprise's portfolio. Thereafter, long- and short-term debt are 
issued in whatever ratio best contributes to maintaining that balance. 
This approach was chosen because OFHEO did not wish to include an 
assumption about any particular behavioral preference by the 
Enterprises during the stress period.
    On further consideration, however, OFHEO proposes to change the 
target balance embodied in this approach. A 50/50 balance is generally 
unsuitable for funding a portfolio of largely fixed-rate mortgage 
assets, and it could often result in a substantial change in an 
Enterprise's funding structure during the stress period. OFHEO proposes 
to replace the 50/50 target with the actual ratio of Enterprise debt 
obligations (as adjusted by interest rate swaps) at the start of the 
stress period. Typically, the Enterprises have a long-term debt to 
total debt ratio (swap adjusted) of 70 percent to 90 percent. Use of 
such ratios in the stress test will result in a more realistic debt 

E. Miscellaneous Technical Changes

    Operating Expenses. In the Rule, one third of an Enterprise's 
operating expenses at the start of the stress test remain fixed 
throughout the stress period, while the remainder decline in proportion 
to the decline in the mortgage portfolio. The total of the fixed and 
variable components is then reduced by one-third to recognize that a

[[Page 65154]]

cessation of new business would have a significant impact upon 
operating expenses. The variable portion of the operating expenses for 
a given month is determined by calculating 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. Starting-position 
fixed-asset balances are held constant over the ten-year stress period, 
while related depreciation is included in the base on which operating 
expenses are calculated for each month of the stress period. The 
implication of this treatment is that fixed assets are being regularly 
replaced throughout the period, which appears inconsistent with the 
decline in financial assets as mortgages amortize and prepay.
    To address this inconsistency, OFHEO is proposing to modify the 
stress test treatment of operating expenses by converting 75 percent of 
starting-position fixed-asset balances to cash over the ten-year stress 
period. The proposal would retain 25 percent of the fixed assets on the 
Enterprise books throughout the stress period to reflect the 
acquisition of some new fixed assets, such as computer equipment, which 
is likely even in a ``wind-down'' scenario. The effect of this change 
is to reduce the Enterprises' need for debt to carry nonearning fixed 
    Float Income. The Rule provides for the modeling of float income 
associated with passthrough payments on securities issued by the 
Enterprises. Float income can be positive or negative depending on 
whether the Enterprise holds the funds for a period of time before 
remitting them to security holders or remits funds to security holders 
before they are actually received. When an Enterprise owns its own 
passthrough securities, the timing of payment to itself is not 
relevant. However, the Rule includes these securities in the 
calculation of float income, resulting in an overstatement of float 
income. OFHEO proposes to correct this overstatement by reducing the 
float income on passthrough securities issued by the reporting 
Enterprise by the percentage of the Enterprise's ownership interest. 
However, when an Enterprise receives prepayments and holds the funds 
for a number of days during which investors accrue interest at the 
coupon rate of the security, the difference between the yield the 
Enterprise can earn on invested funds at that time of the stress period 
and the coupon rate will continue to be reflected for the relevant 
number of days.
    Currency Swaps. As a simplifying assumption in the Rule, OFHEO 
applied no haircut to foreign currency swaps, but stated its intention 
to continue to explore appropriate methodologies for applying an 
appropriate haircut. In furtherance of its commitment to continue to 
refine the stress test, OFHEO now proposes to eliminate the simplifying 
assumption and apply haircuts to foreign currency swap counterparties. 
Because the stress test does not project foreign currency values, the 
haircut is applied by adjusting the pay (dollar-denominated) side of 
the swap upward by the amount of the haircut percentage rather than 
haircutting the foreign-currency receive side of the swap.
    American Call Option. As a simplifying assumption in the Rule, an 
American call option, which allows the issuer to exercise the option at 
any time, is treated as a Bermudan call option, which allows the issuer 
to exercise the call only on a coupon date. However, in the preamble to 
the Rule, OFHEO signaled its intention to consider how American call 
options might be modeled more precisely. OFHEO is now proposing to 
modify the stress test to evaluate American calls on the first option 
date in the exercise schedule and subsequent monthly anniversaries of 
the instrument's first coupon date.
    House Price Growth Factor Clarification. The Rule requires the use 
of OFHEO's most recent House Price Index as of the reporting date to 
determine the house price growth factor used to calculate current loan-
to-value ratios. The proposal expands the instructions in Section 3.6 
to clarify, consistent with Section 3.7, that when a loan was 
originated since the publication of that report, a cumulative house 
price growth factor of one is used.
    Technical Correction. The proposal adds a Prepayment Penalty Flag 
as an additional classification variable for multifamily loan groups, 
to distinguish loans with active prepayment penalties or yield 
maintenance provisions from those without in the calculation of 
prepayment penalty duration for loan groups.

Regulatory Impact

Executive Order 12866, Regulatory Planning and Review

    The proposed amendment would amend a rule designated as a major 
rule by the Office of Management and Budget (OMB). The proposed 
amendment is a refinement of that rule that would tie the capital more 
closely to risk. Although the impact of that refinement is not 
economically significant, OMB has reviewed the proposed amendment to 
determine whether the proposed changes may raise novel policy issues. 
OFHEO is not required to provide the type of regulatory impact analysis 
that is required for an economically significant rule. Nevertheless, in 
accordance with OMB's guidance that all regulatory actions should be 
consistent with the principles of E.O. 12866, OFHEO has determined, 
after review by agency economists, financial analysts, and attorneys, 
that the benefits of the proposed changes to the Rule substantially 
outweigh any economic costs.
    It is impossible to estimate precisely the particular benefits and 
costs associated with the risk-based capital requirement. While OFHEO 
believes this group of enhancements and refinements to the stress test 
will not generally increase or decrease the amount of required capital 
for an Enterprise to any substantial degree, the effect in any 
particular quarter depends upon how well that Enterprise is hedged 
against the risks and conditions specified in the stress test. OFHEO 
cannot know whether or not hedges in place at an Enterprise at the 
beginning of any quarter would have been in place in the absence of 
specific provisions of the risk-based capital rule or were put in place 
because of the test. Speculating as to what the Enterprises would do in 
the absence of specific provisions in future quarters is even more 
difficult. Therefore, a detailed economic cost/benefit analysis is not 
    Rather than trying to assess the costs and benefits of every change 
to the stress test, OFHEO looks to whether or not the changes it is 
proposing make the Rule better reflect the risks faced by the 
Enterprises. Improving the Rule in this manner should reduce the 
potential for Enterprise insolvency by protecting better against 
interest rate, credit, and management and operations risk. By helping 
to ensure the safety and soundness of the Enterprises, the regulation 
allows them to continue to carry out their public purposes, which 
include providing stability in the secondary market for residential 
mortgages and providing access to mortgage credit in central cities, 
rural areas, and underserved areas.\21\ In addition, the regulation 
helps ensure that the Enterprises will continue to provide benefits to 
the primary mortgage market, such as standardizing business 

    \21\ 1992 Act, section 1302(2) (12 U.S.C. 4501(2)).
    \22\ ``Managing Risk in Housing Finance Markets: Perspective 
from the Experience of the United States of America and Mexico,'' 
Mortgage Bankers Association of America (June 11, 1998).


[[Page 65155]]

    Adopting the proposed amendment will result in a capital 
requirement that corresponds more closely to capital levels that the 
marketplace would demand in the absence of the benefits afforded by the 
Government sponsorship of the Enterprises, leading to gains in overall 
economic efficiency. By improving the Rule's ability to reflect actual 
risks at the Enterprises, the amendment also may enhance investor 
confidence in the ability of the stress test to forewarn investors and 
regulators of financial weaknesses. This result would be consistent 
with a study by Standard & Poor's (S&P) that provided risk-to-the-
government credit ratings for the Enterprises.\23\ Although S&P had 
rated Fannie Mae A- and Freddie Mac A+ in 1991, the 1997 report 
upgraded the ratings of both Enterprises to AA-. S&P cited increased 
governmental oversight by OFHEO as an important factor in these higher 
ratings. It further noted that ``OFHEO's regulatory oversight [of 
Freddie Mac] also gives comfort that appropriate interest rate risk 
mitigation steps would be taken as needed.''\24\

    \23\ Final Report of Standard & Poor's to OFHEO, Contract No. 
HE09602C (February 3, 1997).
    \24\ Contract No. HE09602C, at 10.

    OFHEO can identify no significant costs associated with 
implementing the proposed amendments. No new reports are required, and 
net effects on required capital likely will be very small. In sum, the 
benefits to the public, including the Enterprises and other private-
sector concerns, of the proposed changes far outweigh the already 
expended costs of implementing those changes.

Paperwork Reduction Act

    This proposed regulation does not contain any information 
collection requirements that require the approval of the Office of 
Management and Budget under the Paperwork Reduction Act (44 U.S.C. 3501 
et seq.).

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, small businesses, or small organizations must 
include an initial regulatory flexibility analysis describing the 
regulation's impact on small entities. Such an analysis need not be 
undertaken if the agency has certified that the regulation will not 
have a significant economic impact on a substantial number of small 
entities. 5 U.S.C. 605(b). OFHEO has considered the impact of the 
proposed regulation under the Regulatory Flexibility Act. The General 
Counsel of OFHEO certifies that the proposed regulation, if adopted, is 
not likely to have a significant economic impact on a substantial 
number of small business entities because the regulation is applicable 
only to the Enterprises, which are not small entities for purposes of 
the Regulatory Flexibility Act.

List of Subjects in 12 CFR Part 1750

    Capital classification, Mortgages, Risk-based capital.

    Accordingly, for the reasons stated in the preamble, OFHEO proposes 
to amend 12 CFR part 1750 as follows:


    1. The authority citation for part 1750 continues to read as 

    Authority: 12 U.S.C. 4513, 4514, 4611, 4612, 4614, 4618.
    2. Amend Appendix A to subpart B of part 1750 as follows:
    a. Revise Table 3-1 in paragraph 3.1.1;
    b. Revise Table 3-4 in paragraph;
    c. Revise paragraph 3.3.1 [b];
    d. Revise paragraph 3.3.3 [a] 3.c.;
    e. Add new paragraph 3.5.3 [a] 2.d.;
    f. Revise paragraph 3.5.3 [a] 3. and Table 3-31;
    g. In sentence six of paragraph 3.6.1 [e], remove the comma after 
the words ``Credit Losses'', add the word ``and'' in its place, and 
remove the words ``and the Float Income'' after the words ``Guarantee 
    h. Revise paragraph [a] 2.a.;
    i. Revise paragraph [b];
    j. In paragraph, revise Table 3-38;
    k. Revise paragraph [a] 2.;
    l. In paragraph [a] 4, remove the first equation: 
``UWDCRFm = 1 if DCRm  1 in month m'' and add the 
equation ``UWDCRFm = 1 if DCRm  0.98 in month m'' 
in its place;
    m. Revise paragraph [a] 1. and Table 3-39;
    n. Revise paragraph [a] 2.b.;
    o. Revise paragraph [a] 3.;
    p. Revise Table 3-44, in paragraph;
    q. In section, revise the four paragraphs: [a] 1., [a] 
3.b., [a] 4.b. and [a] 5.;
    r. Revise paragraph [a] 9.b.;
    s. Revise paragraph [g] 1.;
    t. In paragraphs [a] 5. and [a] 3., add the words 
``, as appropriate'' at the end of the sentence in each paragraph;
    u. In paragraph 3.7.4 [a] remove reference to ``Table 3-55'' and 
add ``Table 3-61'' in its place;
    v. Redesignate Tables 3-65 through 3-70 as Tables 3-66 through 3-
    w. After paragraph 3.8.1 [e], add new paragraph 3.8.1 [f], new 
footnote 5, and new Table 3-65;
    x. In paragraphs 3.8.2 [a] and [b] remove references to ``Table 3-
65'' and add ``Table 3-66'' in their place;
    y. Revise paragraph [a] 3.a.;
    z. In paragraph remove reference to ``Table 3-66'' and add 
``Table 3-67'' in its place;
    aa. In paragraphs [e] 1. and [e] 2. remove both 
references to ``Table 3-67'' and add ``Table 3-68'' in their place;
    bb. In redesignated Table 3-69 in paragraph, remove both 
references to ``Table 3-65'' and add ``Table 3-66'' in their place;
    cc. Revise paragraphs [a], [b] and [c];
    dd. In paragraph 3.9.2 remove reference to ``Table 3-69'' and add 
``Table 3-70'' in its place;
    ee. In paragraph 3.10.2 [a] remove reference to ``Table 3-70'' and 
add ``Table 3-71'' in its place;
    ff. Revise paragraphs [b] 2. and [b] 3.;
    gg. Revise paragraph [a] 5.; and
    hh. Revise the definition of Enterprise Cost of Funds in paragraph 
4.0 Glossary.
    The revisions and additions read as follows:

Appendix A to Subpart B of Part 1750--Risk-Based Capital Text 
Methodology and Specifications

* * * * *  * * *

[[Page 65156]]

               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
                   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
3.3.2, Interest    3-18, Interest     ....  P
 Rates Inputs       Rate and Index
3.3.3, Interest    3-26, CMT Ratios   ....  ....  F
 Rates Procedures   to the Ten-Year
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
                   3-31, Stress Test  ....  ....  F
                    Maximum Haircut
                    by Ratings
------------------------------------------------------------------------,         3-32, Loan Group   ....  ....  ....  3.3.4, Interest
 Mortgage           Inputs for                           Rates Outputs
 Amortization       Mortgage
 Schedule Inputs    Amortization
------------------------------------------------------------------------, Single  3-34, Single       R     ....  F,
 Family Default     Family Default                       Mortgage
 and Prepayment     and Prepayment                       Amortization
 Inputs             Inputs                               Schedule
------------------------------------------------------------------------,       3-35,              ....  ....  F
 Prepayment and     Coefficients for
 Default Rates      Single Family
 and Performance    Default and
 Fractions          Prepayment
------------------------------------------------------------------------,         3-38, Loan Group   R     ....  F
 Multifamily        Inputs for
 Default and        Multifamily
 Prepayment         Default and
 Inputs             Prepayment
------------------------------------------------------------------------,       3-39, Explanatory  ....  ....  F,
 Default and        Variable                             Mortgage
 Prepayment Rates   Coefficients for                     Amortization
 and Performance    Multifamily                          Schedule
 Fractions          Default                              Outputs
------------------------------------------------------------------------,       3-42, Loan Group   ....  ....  F     3.3.4, Interest
 Single Family      Inputs for Gross                     Rates Outputs
 Gross Loss         Loss Severity             ,
 Severity Inputs                                         Mortgage
                                                         Single Family
                                                         Default and
------------------------------------------------------------------------,       3-44, Loan Group   ....  ....  F     3.3.4, Interest
 Multifamily        Inputs for                           Rates Outputs
 Gross Loss         Multifamily               ,
 Severity Inputs    Gross Loss                           Mortgage
                    Severity                             Amortization
------------------------------------------------------------------------,       3-46, CE Inputs    R     ....  ....,
 Mortgage Credit    for each Loan                        Mortgage
 Enhancement        Group                                Amortization
 Inputs                                                  Schedule
                                                         Single Family
                                                         Default and
                                                         Default and
                                                         Single Family
                                                         Gross Loss
                                                         Gross Loss
                   3-47, Inputs for   R
                    each Distinct CE
------------------------------------------------------------------------, Stress  3-51, Inputs for   R     ....  ....  3.3.4, Interest
 Test Whole Loan    Final                                Rates Outputs
 Cash Flow Inputs   Calculation of            ,
                    Stress Test                          Mortgage
                    Whole Loan Cash                      Amortization
                    Flows                                Schedule
                                                         Single Family
                                                         Default and
                                                         Default and
                                                         Single Family
                                                         and Multifamily
                                                         Net Loss
------------------------------------------------------------------------, Whole   3-54, Inputs for   R     ....  ....,
 Loan Accounting    Whole Loan                           Stress Test
 Flows Inputs       Accounting Flows                     Whole Loan Cash
                                                         Flow Outputs

[[Page 65157]]

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.,            3-66, Input        R
 Nonmortgage        Variables for
 Instrument         Nonmortgage
 Inputs             Instrument Cash
3.9.2.,            3-70, Alternative  R
 Alternative        Modeling
 Modeling           Treatment Inputs
3.10.2.,           3-71, Operations,  R     ....  ....  3.3.4, Interest
 Operations,        Taxes, and                           Rates Outputs
 Taxes, and         Accounting                ,
 Accounting         Inputs                               Stress Test
 Inputs                                                  Whole Loan Cash
                                                         Flow Outputs
                                                        3.7.4., Mortgage-
3.12.2., Risk-     .................  R     ....  ....  3.3.4, Interest
 Based Capital                                           Rates Outputs
 Requirement                                            3.9.4.,
 Inputs                                                  Alternative
                                                         Taxes, and

* * * * *  * * *

                        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
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
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
                                                                            1.80 =DCR1.90
                                                                            1.90 =DCR2.00
                                                                            2.00 =DCR2.50
                                                                            2.50 =DCR4.00
                                                                            DCR >= 4.00
Prepayment Penalty Flag               Indicates if prepayment of the loan   Yes
                                       is subject to active prepayment      No
                                       penalties or yield maintenance

* * * * *

3.3.1  * * *

    [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-

[[Page 65158]]

and 30-year CMTs; fourth, project non-Treasury Interest Rates, 
including the Federal Agency Cost of Funds Index; and fifth, project 
the Enterprises Cost of Funds Index, which provides borrowing rates 
for the Enterprises during the Stress Period, by increasing the 
Agency Cost of Funds Index by 10 basis points for the last 108 
months of the Stress Test.
* * * * *

3.3.3  * * *

    [a] * * *

3. * * *
    c. Enterprise Borrowing Rates. In the Stress Test, the Federal 
Agency Cost of Funds Index is the same as the Enterprise Cost of 
Funds Index during the Stress Period, except that the Stress Test 
adds a 10 basis-point credit spread to the Federal Agency Cost of 
Funds rates to project Enterprise Cost of Funds rates for the last 
108 months of the Stress Period.
* * * * *

3.5.3  * * *

    [a] * * *
2. * * *
    d. The Stress Test will permit a higher rating to be used for an 
unrated seller-servicer who participates in a delegated underwriting 
and servicing program that requires a loss-sharing agreement when: 
(1) The loss sharing agreement is collateralized by a fully funded 
reserve account pledged to the Enterprise; and (2) the reserve 
account is in an amount that is equal to or exceeds the amount that 
OFHEO has determined to be adequate to support the seller-servicer's 
loss-sharing obligation under the program. Determinations of the 
reserve requirement and of the rating that will be permitted will be 
made on a program-by-program and Enterprise-by-Enterprise basis by 
the Director.
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 risk of loss due to counterparty 
(including security) default) by rating category and counterparty 
type as shown in Table 3-31.
    a. The Maximum Haircut for a rating category is the product of 
its default rate and its loss severity rate. For all counterparties 
the default rates are 5 percent for AAA, 12.5 percent for AA, 20 
percent for A, 40 percent for BBB and 100 percent for Below BBB and 
Unrated. For non-derivative counterparties, the loss severity rate 
is 70 percent; for derivative counterparties, it is 10 percent. For 
all Below BBB and Unrated counterparties, the loss severity rate is 
100 percent.
    b. For periods prior to the implementation of netting, a 
separate set of Maximum Haircuts (set forth in Table 3-31) will be 
applied to derivative contract cash flows to approximate the impact 
of the net exposures to derivative contract counterparties (see 
section 3.8.3, Nonmortgage Instrument Procedures). After the 
implementation of netting, exposures will be netted as described in 
section 3.8.3 before the haircut is applied.
    c. With the exception of haircuts for the Below BBB and Unrated 
category, haircuts for all counterparty categories are phased-in 
linearly over the 120 months of the Stress Period. The Maximum 
Haircut is applied in month 120 of the Stress Period. Haircuts for 
the Below BBB and Unrated category are applied fully starting in the 
first month of the Stress Test.

                       Table 3-31.--Stress Test Maximum Haircut by Ratings Classification
                                                    Derivative      Derivative
                                                     Contract        Contract     Non-Derivative
                                                  Counterparties  Counterparties     Contract        Number of
             Ratings Classification                  prior to          after      Counterparties     Phase-in
                                                  Implementation  Implementation  or Instruments      Months
                                                    of Netting      of Netting
Cash                                                          0%              0%              0%             N/A
AAA                                                         0.3%            0.5%            3.5%             120
AA                                                         0.75%           1.25%           8.75%             120
A                                                           1.2%              2%             14%             120
BBB                                                         2.4%              4%             28%             120
Below BBB and Unrated                                       100%            100%            100%               1

* * * * *  * * *

    [a] * * *
2. * * *
    a. LTVq is evaluated for a quarter q as:
    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:

UPBm=3q-3 = UPB for the month at the end of the quarter 
prior to quarter q
CHPGFoLG= 1.0 if the loan was originated in the same 
quarter as or after the most recently available HPI as of the 
reporting date
* * * * *

    [b] Explanatory Variables for Default Rates. Eight explanatory 
variables are used as specified in the equations section, of this Appendix, to determine Default rates for 
multifamily loans: Mortgage Age, Mortgage Age Squared, New Book 
indicator, Not Ratio-updated ARM indicator, 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, Stress Test Whole Loan Cash Flows, of this 
* * * * *

[[Page 65159]]

                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
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
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 of  section 3.4.4, Property
                                       the Stress Test                                Valuation Outputs
RVRm                                  Benchmark Vacancy Rates for months m = 1 120   section 3.4.4, Property
                                       of the Stress Test                             Valuation Outputs
PMTm                                  Scheduled Payment for months m = 1 RM, Mortgage
                                                                                      Amortization Schedule
OE                                    Operating expenses as a share of gross         fixed decimal from
                                       potential rents (0.472)                        Benchmark region and time
RVRo                                  Initial rental vacancy rate                    0.10

* * * * *   * * *

    [a] * * *
2. Assign product and ratio update flags (NBF, NRAF). 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. Not Ratio-updated Arm Flag (NRAF):
NRAF = 1 if both ARMF = 1 and RUF = 0,
NRAF = 0 otherwise.


ARMF = 1 for ARMs (including Balloon ARMs)
ARMF = 0 otherwise, and
RUF = 1 if the LTV and DCR were calculated or delegated to have been 
calculated at origination or recalculated or delegated to have been 
recalculated at Enterprise acquisition according to current 
Enterprise standards.
RUF = 0 otherwise
* * * * *   * * *

    [a] * * *

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 
mth payment; calculate its corresponding logit 
(Xm) based on Loan Group characteristics as of 
the period prior to m, i.e. prior to making the mth payment.

  Table 3-39--Explanatory Variable Coefficients for Multifamily Default
                                                 Default Weight (v)
AY                                                                0.5256
AY2                                                              -0.0284
NBF                                                               -1.219
NRAF                                                              0.4193
DCR                                                               -2.368
UWDCRF                                                             1.220
LTV                                                               0.8165
BMF                                                                1.518
Intercept (0)                                            -4.553

* * * * *
2. * * *
    b. For the down-rate scenario, APRm = 0 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:

If both ARMF = 0 and RUF = 0, then

[[Page 65160]]



* * * * *  * * *

                        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
PTRm                                  Pass Through Rate applicable to payment due    section, Mortgage
                                       in month m (decimal per annum)                 Amortization Schedule
NYRm                                  Net Yield Rate applicable to payment due in    section, Mortgage
                                       month m (decimal per annum)                    Amortization Schedule
RHC                                   Net REO holding costs as a decimal fraction    0.07
                                       of Defaulted UPB
MF                                    Time from Default to completion of             9 months
                                       foreclosure (REO acquisition)
MR                                    Months from REO acquisition to REO             15 months
RP                                    REO proceeds as a decimal fraction of          0.63
                                       Defaulted UPB

* * * * *   * * *

    [a] * * *

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 



m' = m, except for counterparties rated below BBB, where m' = 120

* * * * *
3.* * *
    b. Determine CE Payment in Dollars after application of 


m' = m, except for counterparties rated below BBB, where m' = 120
* * * * *
4.* * *
    b. Determine CE Payment in Dollars after application of 


m' = m, except for counterparties rated below BBB, where m' = 120
* * * * *
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 65161]]


ELPIDCC,C = 0 if ELPFDCC,C = Y (Yes, 
indicating that Contract C is an Enterprise Loss Position)
ELPIDCC,C = 1 otherwise
* * * * *   * * *

    [a] * * *

    9. * * *
    b. Float Income (FI) received in month m

Prepayment Interest Shortfall (PIS) in month m is:

* * * * *   * * *

    [g] * * *

1. Compute:


m' = m, except for MBS credit rating below BBB where m'=120
R = MBS credit rating
* * * * *

3.8.1 * * *

    [f] In a currency swap, the Enterprise receives payments that 
are denominated in a foreign currency and it makes payments in U.S. 
dollars. The main difference between currency swaps and the type of 
swaps discussed above is that in a currency swap principal amounts 
are actually exchanged between the two counterparties. Currency 
swaps are divided into two classes, as shown in Table 3-65 below.\5\

    \5\ Ibid.

                                Table 3-65--Currency Swap Contract Classification
             Classification                                      Description of Contract
Fixed-for-Fixed Currency Swap            Enterprise receives fixed interest payments denominated in a foreign
                                          currency and makes fixed, US$-denominated payments
Fixed-for Floating Currency Swap         Enterprise receives fixed interest payments denominated in a foreign
                                          currency and makes payments in US$ based on a floating interest rate

* * * * *   * * *

    [a] * * *
3. When applying the option exercise rule:
    a. For zero coupon and discount securities, instruments with 
European options, and zero coupon swaps, evaluate option exercise 
only on dates listed in the instrument's option exercise schedule. 
For Bermudan options, evaluate option exercise on the first option 
date in the instrument's option exercise schedule and subsequent 
coupon dates (coupon dates on the fixed-rate leg for swaps). For 
American options, evaluate option exercise on the first option date 
in the instrument's option exercise schedule and subsequent monthly 
anniversaries of the instrument's first coupon date.
* * * * *   * * *

    [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, if 
a counterparty obligation exists. 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. The Haircuts for 
currency swaps are applied to the pay (dollar-denominated) side of 
the currency swaps, or to the cash outflows of the synthetic debt 
instrument. Therefore, the payments made by the Enterprise on a 
foreign currency contract are increased by the haircut amount. The 
Haircuts and the Phase-in periods for currency swaps are detailed in 
Table 3-31, under Derivative Contracts.
    [c] Haircuts for swaps that are not foreign currency related are 
applied to the Monthly Interest Accruals (as calculated in section, of this Appendix) on the receive leg minus the Monthly 
Interest Accruals on the pay leg when this difference is positive. 
Use the maximum haircut from Table 3-31 for periods before and after 
the implementation of netting, as appropriate. After the 
implementation of netting, net the swap proceeds for each 
counterparty before applying the haircuts. The following example 
applies to an Enterprise having two swaps with the same 
counterparty. On the first swap, the Enterprise pays fixed and 
receives floating and on the second swap it pays floating and 
receives fixed. If the counterparty is a net payer to the 
Enterprise, the haircuts will be applied to the sum of the two 
receive legs net of the sum of the two pay legs.
* * * * *  * * *

    [b] * * *
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 long-
term debt is issued to target a total debt mix of short to long term 
debt that is the same as the short to long term debt mix at the 
beginning of the Stress Test. 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 constants and method to calculate the amount of short-term 
and long-term debt to issue in month m:
    a. Set the Issuance Cost on new short-term debt at issue 
    ISCOST = 0.00025
    b. Set the Issuance Cost on new long-term debt at issue 
    ILCOST = 0.002
    c. Calculate Net Short-term Debt Outstanding (NSDO0) 
and Total Debt Outstanding (TDO0) at the start of the

[[Page 65162]]

Stress Test (m = 0) using the following methodology:
    (1) For each month m and each debt and swap instrument i (each 
swap leg is considered a separate instrument), determine the Month 
of Next Repricing (MNRm) defined as the first month 
greater than m in which the instrument matures, an option is 
exercised, or repricing can occur whether or not the coupon rate 
actually changes. Set the Principal Balance (PBm) to be:
    (a) the principal (or notional principal) outstanding if the 
instrument cash flows are paid by the Enterprise,
    (b) minus the principal (or notional principal) outstanding if 
the instrument cash flows are received by the Enterprise.
    (2) Calculate NSDOm by summing PBm,i for 
all instruments where MNRm,i is less than or equal to m 
plus 12.
    (3) Calculate TDOm by summing PBm,i for 
instruments where MNRm,i is greater than m.
    d. Set the Maximum Proportion of Total Debt (MPD):
    e. Calculate Discount Rate Factor (DRFm):
Where: CFm = six month Enterprise Cost of Funds for month 
    f. Calculate the Adjustment Factor for Short-Term Debt Issuance 
Fees (AFSIFm):

    g. Calculate the Adjustment Factor for Long-Term Debt Issuance 
Fees (AFLIFm):

    h. Calculate the Maximum Long-Term Issuance (MLTIm):
    i. Calculate Net Short-Term Debt Outstanding (NSDOm) 
and Total Debt Outstanding (TDOm) for month m using the 
methodology described in section 3.c. of this section. Note: This 
calculation must reflect all new issuances, option exercises, and 
maturities between the beginning of the Stress Test and month m.
    j. Calculate Interim Face Amount of Long-Term Debt to be issued 
this month (IFALDm):

    k. Calculate Face Amount of Long-Term Debt to be issued 

    l. Calculate Face Amount of Short-Term Debt to be issued 

* * * * * * * *

    [a] * * *
5. Fixed Assets. 25 percent of fixed assets (net of accumulated 
depreciation) as of the beginning of the Stress Test remain constant 
over the Stress Test. The remaining 75 percent is converted to cash 
on a straight line basis over the ten-year Stress Period. 
Depreciation is included in the base on which operating expenses are 
calculated for each month during the Stress Period.
* * * * *

4.0 * * *

    Enterprise Cost of Funds: Cost of funds used in computing the 
cost of new debt for the Enterprises during the Stress Test, as 
specified in section 3.3.3[a]3.c., of this Appendix.
* * * * *

    Dated: December 11, 2001.
Armando Falcon, Jr.,
Director, Office of Federal Housing Enterprise Oversight.

[FR Doc. 01-30898 Filed 12-17-01; 8:45 am]