[Federal Register Volume 72, Number 233 (Wednesday, December 5, 2007)]
[Proposed Rules]
[Pages 68656-68659]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 07-5101]



[[Page 68655]]

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Part III





Department of Housing and Urban Development





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Office of Federal Housing Enterprise Oversight



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12 CFR Part 1750



Risk[dash]Based Capital Regulation--Loss Severity Amendments; Proposed 
Rule

  Federal Register / Vol. 72, No. 233 / Wednesday, December 5, 2007 / 
Proposed Rules  

[[Page 68656]]


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DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT

Office of Federal Housing Enterprise Oversight

12 CFR Part 1750

RIN 2550-AA38


Risk-Based Capital Regulation--Loss Severity Amendments

AGENCY: Office of Federal Housing Enterprise Oversight, HUD.

ACTION: Notice of Proposed Rulemaking.

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SUMMARY: The Office of Federal Housing Oversight (OFHEO) is amending 
Appendix A to Subpart B of 12 CFR part 1750 Risk-Based Capital (Risk-
Based Capital Regulation). The amendments are intended to enhance the 
accuracy and transparency of the calculation of the risk-based capital 
requirement for the Federal National Mortgage Association (Fannie Mae) 
and the Federal Home Loan Mortgage Corporation (Freddie Mac) 
(collectively the Enterprises). OFHEO proposes to amend further the 
Risk-Based Capital Regulation to change the loss severity equations 
that understate losses on defaulted single-family conventional and 
government guaranteed loans. OFHEO also proposes to amend the treatment 
of Federal Housing Administration (FHA) insurance in the Risk-Based 
Capital Regulation in order to conform the treatment to current law.

DATES: Comments regarding this Notice of Proposed Rulemaking must be 
received in writing on or before March 4, 2008. For additional 
information, see SUPPLEMENTARY INFORMATION.

ADDRESSES: You may submit your comments on the proposed rulemaking, 
identified by ``RIN 2550-AA38,'' by any of the following methods:
     U.S. Mail, United Parcel Post, or other Mail Service: The 
mailing address for comments is: Alfred M. Pollard, General Counsel, 
Attention: Comments/RIN 2550-AA38, Office of Federal Housing Enterprise 
Oversight, Fourth Floor, 1700 G Street, NW., Washington, DC 20552.
     Hand Delivery/Courier: The hand delivery address is: 
Alfred M. Pollard, General Counsel, Attention: Comments/RIN 2550-AA38, 
Office of Federal Housing Enterprise Oversight, Fourth Floor, 1700 G 
Street, NW., Washington, DC 20552. The package should be logged at the 
Guard Desk, First Floor, on business days between 9 a.m. and 5 p.m.
     E-mail: Comments to Alfred M. Pollard, General Counsel, 
may be sent by e-mail at [email protected]. Please include ``RIN 
2550-AA38'' in the subject line of the message.

FOR FURTHER INFORMATION CONTACT: David A. Felt, Deputy General Counsel, 
telephone (202) 414-3750, or Jamie Schwing, Associate General Counsel, 
telephone (202) 414-3787 (not toll free numbers), 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.

SUPPLEMENTARY INFORMATION:

I. Comments

    OFHEO invites comment on all aspects of the proposed amendments to 
the Risk-Based Capital Regulation, and will take all relevant comments 
into consideration before issuing the final regulation. OFHEO requests 
that comments submitted in hard copy also be accompanied by the 
electronic version in Microsoft[supreg] Word or in a portable document 
format (PDF) on 3.5 disk or CD-ROM.
    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 on business 
days between the hours of 10 a.m. and 3 p.m. at the Office of Federal 
Housing Enterprise Oversight, Fourth Floor, 1700 G Street, NW., 
Washington, DC 20552. To make an appointment to inspect comments, 
please call the Office of General Counsel at (202) 414-3751.

II. Background

    Title XIII of the Housing and Community Development Act of 1992, 
Pub. L. 102-550, titled the Federal Housing Enterprise Financial Safety 
and Soundness Act of 1992 (the Act) (12 U.S.C. 4501 et seq.) 
established OFHEO as an independent office within the Department of 
Housing and Urban Development to ensure that the Enterprises are 
adequately capitalized, operate safely and soundly, and comply with 
applicable laws, rules and regulations. The Act provides that the 
Director of OFHEO (the Director) is authorized to make such 
determinations and take such actions as the Director determines 
necessary with respect to the issuance of regulations regarding, among 
other things, the required capital levels for the enterprises.\1\ The 
Act further provides that the Director shall issue regulations 
establishing the risk-based capital test and that the Risk-Based 
Capital Regulation, subject to certain confidentiality provisions, 
shall be sufficiently specific to permit an individual other than the 
Director to apply the risk-based capital test in the same manner as the 
Director.\2\
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    \1\ 12 U.S.C. 4513(a), (b)(1), (b)(3).
    \2\ 12 U.S.C. 1361(e)(1), (e)(3).
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    Pursuant to the Act, OFHEO published a final regulation setting 
forth a risk-based capital test which forms the basis for determining 
the risk-based capital requirement for each Enterprise.\3\ The Risk-
Based Capital Regulation has been amended to incorporate corrective and 
technical amendments that enhance the accuracy and transparency of the 
calculation of the risk-based capital requirement.\4\
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    \3\ Risk-Based Capital, 66 FR 44730 (September 13, 2001), 12 CFR 
part 1750.
    \4\ Risk-Based Capital, 66 FR 44730 (September 13, 2001), 12 CFR 
part 1750, as amended, 67 FR 11850 (March 15, 2002), 67 FR 19321 
(April 19, 2002), 67 FR 66533 (November 1, 2002), 68 FR 7309 
(February 13, 2003), 71 FR 75085 (December 14, 2006).
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    Consistent with the Act, OFHEO proposes to amend further the Risk-
Based Capital Regulation to change certain loss severity equations that 
understate losses on defaulted single-family conventional and 
government guaranteed loans. OFHEO also proposes to amend the treatment 
of FHA insurance in the Risk-Based Capital Regulation in order to 
conform the treatment to current law.
    As currently specified, certain loss severity equations allow the 
Enterprises to record negative losses (i.e., profits) on foreclosed 
mortgages during the calculation of the risk-based capital requirement. 
Unaltered, the current loss severity equations overestimate Enterprise 
recoveries for defaulted government-guaranteed and low loan-to-value 
(LTV) loans. The results generated by the current loss severity 
equations are not consistent with the goals of the Risk-Based Capital 
Regulation and result in significant reductions in the risk-based 
capital requirements of the Enterprises. The amendments to the relevant 
equations are set forth below.

A. Loss Severity

    Loss Severity is the net cost to an Enterprise of a mortgage loan 
default. The Risk-Based Capital Regulation uses the costs associated 
with different events following the default of a mortgage to determine 
the total loss or cost to an Enterprise. Loss severity rates are 
computed as of the date of default and are expressed as a percentage of 
the unpaid principal balance of a defaulting loan. In general, losses 
on a loan include the unpaid principal balance of the loan, lost 
interest, foreclosure costs, and expenses related to real-estate-owned. 
See paragraph 3.6.3.6.1, Calculation of

[[Page 68657]]

Single Family and Multifamily Mortgage Losses Overview.\5\ Losses may 
be reduced by mortgage insurance proceeds, pool-level credit 
enhancement proceeds, and recovery proceeds from the sale of the 
foreclosed property, as set forth at paragraph 3.6.1[h], subtitled 
Specification of Mortgage Default and Loss and paragraph 3.6.3.6.2.1, 
subtitled, Single Family Gross Loss Severity Overview.\6\
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    \5\ 12 CFR part 1750 (2006), Subpart B, Appendix A, ] 
3.6.3.6.1[c].
    \6\ Id. ] 3.6.1[h] and ] 3.6.3.6.2.1.
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    Since the adoption of the Risk-Based Capital Regulation, OFHEO has 
gained extensive operating experience with the administration of the 
rule. A review of the loss severity equations as currently specified 
indicates that changes are required to correct deficiencies in the 
equations related to the calculation of loss severity rates for single-
family conventional and FHA mortgages and single-family Department of 
Veterans Affairs (VA) mortgages. In addition, the current treatment of 
FHA insurance associated with single-family loans with an LTV below 78% 
is inconsistent with current law and should be corrected as detailed 
below.
i. Conventional Single-Family Loan Groups
    The current treatment for calculating loss severity rates for 
conventional single-family loan groups is set forth in the Risk-Based 
Capital Regulation, paragraph 3.6.3.6.5.1, as a subtopic under the 
general heading of Single Family and Multifamily Net Loss Severity 
Procedures.\7\ The following equation shows the loss severity model for 
conventional and FHA mortgages in the RBC regulation:
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    \7\ Id. ] 3.6.3.6.5.1[a].
    [GRAPHIC] [TIFF OMITTED] TP05DE07.015
    
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Where:

LSmSF = Net loss severity for conventional and 
FHA single-family loans in month m
MIm = Mortgage insurance proceeds in month m
ALCEm = Aggregate limit credit enhancement in month m
MR = Months to recovery
F = Foreclosure costs
MQ = Months delinquent
PTRm = Pass through rate for payments in month m
R = REO expenses
RPm = (0.61/LTVq) = Recovery proceeds in month 
m. The 0.61 is the recovery rate on defaulted loans in the benchmark 
loss experience as a percentage of the predicted house price using 
the HPI.
LTVq = Loan to value ratio in month q (current LTV)
DRm = Discount rate in month m

    This equation produces negative losses (profits) for low LTV loans. 
This result, profits on defaults, is inconsistent with the stress 
environment envisioned by the statute. Specifically, the problem arises 
with the term used to estimate the value of recovery proceeds as a 
percentage of the loan amount outstanding, RPm, which is set 
equal to 0.61/LTVq. This term yields a value greater than 
one when LTVq falls below 61%, resulting in the projected 
recovery proceeds exceeding the defaulted UPB. If the projected 
recovery proceeds exceed the other costs as well as the defaulted UPB, 
the result is a negative loss (profit).
    More specifically, RPm is problematic because it relies 
on LTVq, which represents the estimated current LTV of a 
loan, assuming the mortgaged property has appreciated in value at the 
mean rate for the Census Division. Because LTVq incorporates 
mean rather than actual house price appreciation, using LTVq 
to measure how the loan amount compares to the property value can be 
misleading. Not all property values change at the mean rate; some 
perform less well. Loans with low LTVq values that default 
generally are collateralized by properties whose values appreciated 
much less than properties securing other loans originated at the same 
time, and in the same Census Division. Such loans would normally only 
default rather than prepay if the defaulting borrowers cannot fully pay 
off the loan by selling the house because their actual current LTV 
ratio is higher than LTVq. Thus the recovery rate generally 
is less than 61% on these defaulted loans.
    The problem with the estimate of recovery proceeds has become 
acute, because the volume of loans in the Enterprises' portfolios with 
low LTVq has increased sharply in recent years due to 
rapidly rising house prices. While only a very small percentage of 
loans with low values of LTVq default in the RBC model, 
there are now so many loans with low LTVq values that the 
effects are pronounced. When this model specification was selected, 
this problem was relatively small, as there were few defaulting loans 
generating gains. Alternative specifications that avoided this issue 
added considerable complexity to the model and had other problems.
    Profiting on defaults also is not consistent with the credit stress 
environment envisioned in the Risk-Based Capital Regulation. Despite 
having a low LTV, a homeowner may face unemployment and an illiquid 
housing market in the RBC stress environment. Upon foreclosure, the 
Enterprise would face the challenge of selling the property in the same 
illiquid market, making the prospect of a profit highly unlikely. 
Substantial profits on defaulted loans would be unlikely in any event 
because the law in a number of states requires any ``extra'' proceeds 
from a foreclosure to revert to the mortgagee, not the holder of the 
mortgage.
    OFHEO proposes to correct the loss severity equation for 
conventional and FHA mortgages such that the results of the equation 
are constrained to be non-negative. This change will eliminate the 
possibility of the Enterprises profiting on defaulted mortgages in the 
stress test model. The change addresses the weakness in the recovery 
equation and produces results that are more consistent with the credit 
stress environment envisioned in the RBC Regulation.
    As part of its analysis, OFHEO considered two alternatives. One 
alternative would have restricted recovery proceeds to 120% of the 
outstanding loan amount.\8\ Another alternative considered would have 
required the loss severity equation to be non-negative, except that MI 
and aggregate level credit enhancements payments would be received in 
full. These alternatives were not proposed

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because they would produce gains on defaults for certain loans.
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    \8\ The 120% figure reflects the total costs observed on 
defaulted loans in the benchmark loss experience (the loan amount 
(100%), the foreclosure expenses (3.7%) and real estate-owned (REO) 
expenses (16.3%).
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ii. Veterans Administration Mortgages
    The current treatment for calculating loss severities for single-
family VA-guaranteed mortgages is set forth in the Risk-Based Capital 
Regulation at paragraph 3.6.3.6.5.1 as a subtopic under the general 
heading of Single Family and Multifamily Net Loss Severity 
Procedures.\9\ The current loss severity equation for VA loans utilizes 
the same equation for recovery proceeds as the conventional and FHA 
loss severity equation, and thus may also generate negative losses. In 
order to address this issue, OFHEO proposes an amendment to revise the 
loss severity equation for VA loans such that the results of the 
equation are constrained to be non-negative.
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    \9\ 12 CFR part 1750 (2006), Subpart B, Appendix A, ] 
3.6.3.6.5.1[b]2.
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    During the development of this proposed amendment, OFHEO considered 
removing the recovery proceeds term from the VA loss severity equation 
in order to reduce the negative losses. However, this alternative does 
not accurately reflect the VA guarantee program, which may allow both 
recovery proceeds and the VA guarantee to be used to offset losses.
iii. Federal Housing Administration Insurance
    The current treatment for consideration of FHA insurance in the 
calculation of loss severities is set forth in the Risk-Based Capital 
Regulation. See paragraph 3.6.3.6.4.3, as a subtopic under the general 
heading Mortgage Credit Enhancement Procedures.\10\ The current 
equation cancels mortgage insurance for all loans when the LTV falls 
below 78%. Although this treatment is appropriate for loans with 
private mortgage insurance, FHA insurance remains in force irrespective 
of the LTV of a mortgage. OFHEO proposes not to cancel FHA insurance by 
amending the current equation.
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    \10\ Id. ] 3.6.3.6.4.3[a]1.
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B. Capital Impact of Proposed Amendments

    The following table shows the estimated capital impact of all of 
the proposed amendments at September 30 and December 31, 2006.

                            Table 1.--Estimated Capital Impact of Proposed Amendments
                                              [Billions of dollars]
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                                                                                  RBC requirement
                                                                 -----------------------------------------------
                                                  Interest rate                       Current
                                    Quarter          scenario         Current       regulation
                                                                    regulation    with  proposed     Change *
                                                                                     amendments
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Fannie Mae...................  2006 3Q.........  Up-Rate........           $22.5           $32.0            $9.5
                                                 Down-Rate......            16.4            25.1             8.6
                               2006 4Q.........  Up-Rate........            26.9            36.6             9.8
                                                 Down-Rate......             9.1            16.6             7.5
Freddie Mac..................  2006 3Q.........  Up-Rate........            14.9            19.4             4.5
                                                 Down-Rate......            13.8            18.2             4.4
                               2006 4Q.........  Up-Rate........            15.3            20.7             5.4
                                                 Down-Rate......            12.9            17.5             4.5
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* Figures may not sum precisely due to rounding.

    The proposed amendments substantially increase the RBC Requirement 
in both the up and down interest rate scenarios for both Enterprises 
for the two quarters analyzed. However, if the proposed amendments had 
been in effect during the analyzed periods, total capital would have 
exceeded the RBC Requirement and the capital classifications of the 
Enterprises would not have changed.

Regulatory Impacts

Executive Order 12866, Regulatory Planning and Review

    The proposed amendments to the Risk-Based Capital Regulation 
incorporate corrections to the loss severity equations used to 
calculate the risk-based capital requirements of the Enterprises. The 
proposed amendments to the Risk-Based Capital Regulation are not 
classified as an economically significant rule under Executive Order 
12866 because they do not result in an annual effect on the economy of 
$100 million or more or a major increase in costs or prices for 
consumers, individual industries, Federal, state or local government 
agencies, or geographic regions; or have any significant adverse 
effects on competition, employment, investment, productivity, 
innovation, or on the ability of United States-based enterprises to 
compete with foreign-based enterprises in foreign or domestic markets. 
Accordingly, no regulatory impact assessment is required. However, as a 
regulatory action with significant policy implications, the proposed 
amendments were submitted to the Office of Management and Budget for 
review under applicable provisions of Executive Order 12866.

Executive Order 13132, Federalism

    Executive Order 13132 requires that Executive departments and 
agencies identify regulatory actions that have significant federalism 
implications. A regulation has federalism implications if it has 
substantial direct effects on the states, on the relationship or 
distribution of power between the Federal Government and the states, or 
on the distribution of power and responsibilities among various levels 
of government. The Enterprises are federally chartered entities 
supervised by OFHEO. The proposed amendments to the Risk-Based Capital 
Regulation address matters with which the Enterprises must comply for 
Federal regulatory purposes. The proposed amendments to the Risk-Based 
Capital Regulation address matters regarding the risk-based capital 
calculation for the Enterprises and therefore does not affect in any 
manner the powers and authorities of any state with respect to the 
Enterprises or alter the distribution of power and responsibilities 
between Federal and state levels of government. Therefore, OFHEO has 
determined that the proposed amendments to the Risk-

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Based Capital Regulation have no federalism implications that warrant 
preparation of a Federalism Assessment in accordance with Executive 
Order 13132.

Paperwork Reduction Act

    The proposed amendments do not contain any information collection 
requirement that requires the approval of OMB 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 does 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 amendments to the Risk-Based Capital Regulation under the 
Regulatory Flexibility Act. The General Counsel of OFHEO certifies that 
the proposed amendments to the Risk-Based Capital Regulation are 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 is 
amending 12 CFR part 1750 as follows:

PART 1750--CAPITAL

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

    Authority: 12 U.S.C. 4513, 4514, 4611, 4612, 4614, 4618.

    2. Amend Appendix A to subpart B of part 1750 as follows:
    a. In paragraph 3.6.3.6.4.3[a]1, revise the explanation following 
the equation;
    b. In paragraph 3.6.3.6.5.1[a] revise equation;
    c. In paragraph 3.6.3.6.5.1[b]2 revise equation.

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

* * * * *

3.6.3.6.4.3 * * *

    [a] * * *
1. * * *
Where:

m' = m, except for counterparties rated below BBB, where m' = 120
[GRAPHIC] [TIFF OMITTED] TP05DE07.016

* * * * *

3.6.3.6.5.1 * * *

    [a] * * *
    [GRAPHIC] [TIFF OMITTED] TP05DE07.017
    
    [b] * * *
2. * * *
[GRAPHIC] [TIFF OMITTED] TP05DE07.018

* * * * *

    Dated: October 11, 2007.
James B. Lockhart III,
Director, Office of Federal Housing Enterprise Oversight.

[FR Doc. 07-5101 Filed 12-4-07; 8:45 am]
BILLING CODE 4220-01-P