OFHEO's Risk-Based Capital Stress Test: Incorporating New Business Is Not Advisable (06/28/2002, GAO-02-521}

-------------------------Indexing Terms-------------------------
REPORTNUM:   GAO-02-521
    TITLE:   OFHEO's Risk-Based Capital Stress Test: Incorporating New Business Is Not Advisable
     DATE:   06/28/2002



This is the accessible text file for GAO report number GAO-02-521 
entitled 'OFHEO's Risk-Based Capital Stress Test: Incorporating New 
Business Is Not Advisable' which was released on June 28, 2002.



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United States General Accounting Office:



GAO: Report to Congressional Committees:



June 2002: OFHEOï¿½s Risk-Based Capital Stress Test: Incorporating New 

Business Is Not Advisable:



GAO-02-521:



Contents:



Letter:



Results in Brief:



Background:



New Business Has a Substantial Impact on the Enterprisesï¿½ Financial 

Health, Level of Risks, and Capital Adequacy:



Incorporating New Business Assumptions Is Difficult and Inherently 

Speculative:



Supervisory Review Can Be Another Effective Tool for Limiting the 

Potential Risks of New Business:



Conclusions:



Recommendation:



Agency Comments and Our Evaluation:



Appendix I: HUD Regulates the Enterprisesï¿½ Housing Goal Requirements:



Appendix II: The Business of the Enterprises:



Appendix III: Comments from Freddie Mac:



Related GAO Products:



Tables:



Table 1: Enterprise Purchases of Single-Family Mortgages Compared with 

Originations and the Prior Yearï¿½s Mortgage Portfolio, 1991-2000:



Table 2: Selected Enterprise On-Balance Sheet Holdings and Liabilities 

as of December 31, 2001:



Table 3: Total Mortgage Portfolio of the Enterprises, Year-End 2001:



Table 4: Selected Data on Enterprise Income and Expenses for the year 

ending December 31, 2001:



Abbreviations:



HUD: Department of Housing and Urban Development

MBS: mortgage-backed securities 

FCA: Farm Credit Administration

FHFB: Federal Housing Finance Board

FHLBank: Federal Home Loan Bank

GSE: Government-Sponsored Enterprise

OFHEO: Office of Federal Housing Enterprise Oversight

PCA: Prompt Corrective Actions:



June 28, 2002:



Congressional Committees:



This report responds to a mandate in the Federal Housing Enterprises 

Financial Safety and Soundness Act of 1992 (the act)[Footnote 1] that 

we study whether the Office of Federal Housing Enterprise Oversight 

(OFHEO) should incorporate new business assumptions into the stress 

test used to establish risk-based capital requirements. The stress test 

is designed to estimate, for a 10-year period, how much capital the 

Federal National Mortgage Association (Fannie Mae) and the Federal Home 

Loan Mortgage Corporation (Freddie Mac) would be required to hold to 

withstand potential economic shocks, such as sharp movements in 

interest rates or adverse credit conditions.[Footnote 2] Incorporating 

new business assumptions into the stress test would mean specifying 

details about the types and quality of new mortgages that would be 

acquired during the 10-year stress period, the types of funding that 

would be used to acquire such mortgages, and other operating and 

financial strategies that would be implemented by Fannie Maeï¿½s and 

Freddie Macï¿½s (the enterprises) managements. Under the terms of the 

act, the current test assumes that the enterprises do not contract for 

any new business beyond what is on the books at the time of the test. 

OFHEO issued its risk-based capital rule on September 13, 

2001.[Footnote 3] Four years after issuing its risk-based capital rule, 

OFHEO has the option to incorporate new business assumptions into the 

test. Our mandate is to provide, within the first year after the rule 

is issued, an opinion on the advisability of including new business 

after the initial 4-year period.[Footnote 4]



As agreed with your offices, our objectives were to (1) analyze the 

effects that new business could have on the enterprisesï¿½ financial 

condition and capital adequacy; (2) analyze the challenges of 

incorporating new business assumptions into the stress test, including 

any potentially adverse consequences; and (3) consider the efficacy of 

using supervisory review in conjunction with the current stress test to 

address the potential risks associated with new business.



To complete our work, we reviewed (1) the 1992 act and its legislative 

history; (2) enterprise capitalization studies conducted by the 

Department of Housing and Urban Development (HUD) prior to OFHEOï¿½s 

establishment; (3) OFHEOï¿½s current risk-based capital regulation and 

public comments made on previously proposed risk-based capital rules; 

(4) historic financial data pertaining to the balance sheets and new 

business activities of the enterprises; (5) each enterpriseï¿½s risk-

management practices and financial models used for planning and risk-

management purposes; and (6) related literature. We did not verify 

financial data on the enterprises or provided by OFHEO, nor did we 

review the mechanics of the OFHEO stress test model. We also 

interviewed officials from the enterprises, HUD, OFHEO, and rating 

agencies, as well as individuals engaged in developing risk-based 

capital models for financial institutions. Our scope was limited to our 

study mandate and its focus on new business assumptions, so we did not 

make an overall evaluation of OFHEOï¿½s current risk-based capital rule 

or stress test, except as they directly applied to our study mandate.



We conducted our work in Washington, D.C., between September 2001 and 

April 2002, in accordance with generally accepted government auditing 

standards.



Results in Brief:



New business is an important determinant of the expected future 
financial 

condition of both Fannie Mae and Freddie Mac. Data for the enterprises 

show that new business conducted over a 10-year period generally 
accounts 

for a large share of their on- and off-balance sheet holdings of assets 

and liabilities at the end of each 10-year period. Because new business 

represents such a large share of enterprise holdings over time, it 
would 

have a major impact on the enterprisesï¿½ financial condition, risks, and 

capital adequacy in the face of stressful events.



However, determining the appropriate new business assumptions to 

include in OFHEOï¿½s model would be difficult and inherently speculative. 

To incorporate new business assumptions, OFHEO would have to develop 

plausible scenarios for how enterprise management and the market would 

respond in a stressful environment. For instance, OFHEO would need to 

consider managementï¿½s capacity, not only to make appropriate 

adjustments in the face of uncertainty but, it would also have to make 

assumptions about actions the enterprises might take to improve their 

financial condition. Another factor to consider would be HUDï¿½s 

regulatory behavior during periods of stress, because the Secretary of 

HUD has exclusive authority to promulgate and enforce numeric housing 

goals for the enterprises. The fact that the enterprises do not 

incorporate new business assumptions into their own long-term capital 

adequacy models illustrates the difficulties involved. The enterprises 

generally incorporate new business assumptions only into financial 

models for relatively short-term planning (4 years or less). In 

addition, incorporating new business assumptions would increase the 

complexity of OFHEOï¿½s already complex stress test, making it more 

difficult to understand and replicate. Because of the importance of new 

business and the speculative nature of any assumptions about enterprise 

behavior, the assumptions required could dominate the capital 

requirement.



OFHEO has another tool it can use to limit risk taking by the 

enterprises. Supervisory review, which includes examination of the 

enterprisesï¿½ ongoing business activities and enforcement actions, 

should work in conjunction with the capital requirement to help ensure 

the safety and soundness of the enterprises. OFHEO is authorized to 

take actions to limit risk taking when an enterpriseï¿½s financial 

condition is jeopardized. Financial regulators tend to rely on 

supervisory review to respond when specific practices occur that could 

pose a safety and soundness concern.



This report contains a recommendation to the director of OFHEO that the 

agency not incorporate new business assumptions into its stress test, 

because determining the assumptions is inherently speculative and 

including them would introduce more complexity to an already complex 

model.



Background:



Congress established and chartered the enterprisesï¿½Fannie Mae and 

Freddie Macï¿½as government-sponsored enterprises (GSE) that are 

privately owned and operated. Their mission is to enhance the 

availability of mortgage credit across the nation during both good 

and bad economic times by purchasing mortgages from lenders (banks, 

thrifts, and mortgage bankers) that use the proceeds to make additional 

mortgage loans to home buyers. The enterprises issue debt to finance 

some of the mortgage assets they retain in their portfolios. Most 

mortgages purchased by the enterprises are conventional mortgages, 

which have no federal insurance or guarantees. Enterprise purchases 

are subject to a conforming loan limit [Footnote 5] that currently 

stands at $300,700 for a single-unit home.



The debt and mortgage assets in the enterprisesï¿½ portfolios are on-

balance sheet obligations (liabilities) and assets, respectively. A 

majority of the mortgages, however, are placed in mortgage pools to 

support mortgage-backed securities (MBS) that may be sold to investors 

or repurchased by the enterprises and held in their portfolios. MBS are 

conduits for collecting principal and interest payments from mortgages 

in the mortgage pools and passing payments onto MBS investors. The 

enterprises charge fees for guaranteeing the timely payment of 

principal and interest on MBS held by investors. MBS held by investors 

other than the enterprises are off-balance sheet obligations of the 

enterprises.



The federal governmentï¿½s creation of and continued relationship with 

Fannie Mae and Freddie Mac have created the perception in financial 

markets that the government will not allow the enterprises to default 

on their debt and MBS obligations, although no such legal requirement 

exists. As a result, Fannie Mae and Freddie Mac can borrow money in the 

capital markets at lower interest rates than comparably creditworthy 

private corporations that do not enjoy federal sponsorship. At least a 

portion of the financial benefits that accrue to the enterprises have 

been passed along to homeowners in the form of lower mortgage interest 

rates.



During the 1980s, the government did provide limited regulatory and 

financial relief to Fannie Mae when the enterprise was experiencing 

significant financial difficulties; and in 1987, Congress authorized $4 

billion to bail out the Farm Credit System, another GSE. Recognizing 

the potentially large costs that Fannie Mae and Freddie Mac pose to 

taxpayers, Congress passed the act, which established OFHEO as an 

independent regulator within HUD--tasked with ensuring the enterprisesï¿½ 

safety and soundness. OFHEOï¿½s director has broad independent authority 

to ensure that OFHEO fulfills its safety and soundness mission. For 

example, the director has the authority to take supervisory and 

enforcement actions regarding the safety and soundness of the 

enterprises without the review and approval of the Secretary of HUD.



The act requires OFHEO to carry out its oversight function both by 

establishing and enforcing minimum capital standards (including the 

risk-based capital standard) and by conducting annual on-site safety 

and soundness examinations of the enterprises to assess their 

operations and financial condition. The act established the broad 

outlines of a stress test and mandated that OFHEO develop its stress 

test within those parameters to serve as the basis for the risk-based 

capital standards.[Footnote 6] The act requires the stress test to 

simulate situations that expose the enterprises to extremely adverse 

credit and interest rate scenarios over a 10-year period and to 

calculate the cash flows and the amount of capital the enterprises 

would need to continue to operate for the entire period. The stress 

test model must include upward and downward interest rate movements of 

up to 6 percentage points and assume a high level of credit risk (based 

on the worst cumulative credit loss for not less than 2 consecutive 

years in contiguous states encompassing at least 5 percent of the U.S. 

population). As required in the act, the stress test model that the 

agency developed estimates credit [Footnote 7] and interest 

rate[Footnote 8] risks, among other factors, and includes an additional 

30 percent of that amount for management and operations risk.[Footnote 

9] Also as required, it does not include new business assumptions. The 

act set a December 1, 1994, deadline for completion of the stress test 

and risk-based capital standards.



HUD is the mission regulator of the enterprises. The Secretary of HUD 

has general regulatory power over the enterprises to ensure that they 

carry out their mission as stated in their charters. The act requires 

the Secretary to establish annual goals for purchases of mortgages on 

low-and moderate-income housing, special affordable housing, and 

housing in central cities, rural areas, and other under-served areas. 

When HUD establishes housing goals, it must look at several factors, 

including the need for the enterprises to remain in sound financial 

condition. For more information about HUDï¿½s mission regulation, see 

appendix I.



New Business Has a Substantial Impact on the Enterprisesï¿½ Financial 

Health, Level of Risks, and Capital Adequacy:



The enterprises are in the business of buying and holding mortgages 

and insuring mortgage cash flows to investors. New business accounts 

for a large share of the enterpriseï¿½s on- and off-balance sheet 
holdings 

and thus has a major impact on their activities and financial health. 

The financial health of the enterprises and their ability to survive a 

future stressful economic period depend on the level of risk in both 

their existing and new business; the amount of capital that is 
available 

to them to absorb any lossesï¿½their capital adequacy; and the business 

decisions they make during the stressful period.



New Business Affects the Enterprisesï¿½ Financial Condition:



The enterprises continually acquire mortgages originated by lenders for 

home purchases and for refinancing existing mortgages (see table 1). 

Such mortgage acquisitions are a large share of total originations in 
any 

year and are often large relative to mortgage holdings at the end of 
the 

prior year. For example, the enterprisesï¿½ purchases equaled between 32 

and 51 percent of total single-family originations in each year between 

1991 and 2000. [Footnote 10] In addition, their yearly purchases 
between 1991 and 2000 

ranged from about 17 to 51 percent of their total mortgage portfolios 
in 

the prior year [Footnote 11]. 



Table 1: Enterprise Purchases of Single-Family Mortgages Compared with 

Originations and the Prior Yearï¿½s Mortgage Portfolio, 1991-2000:



Dollars in millions.



Year: 1991; Total enterprise purchases: $233,280; Total originations: 

$562,074; Enterprise purchases as a percentage of originations: 41.50; 

Prior yearï¿½s total enterprise mortgage portfolios: $740,020;  
Enterprise 

purchases as a percentage of prior yearï¿½s portfolios: 31.52.



Year: 1992; Total enterprise purchases: 439,309; Total originations: 

893,666; Dollars in millions: Enterprise purchases as a percentage of 

originations: 49.16; Prior yearï¿½s total enterprise mortgage portfolios: 

867,793; Enterprise purchases as a percentage of prior yearï¿½s 
portfolios: 

50.62.



Year: 1993; Total enterprise purchases: 518,877; Total originations: 

1,019,861; Enterprise purchases as a percentage of originations: 50.88; 

Prior yearï¿½s total enterprise mortgage portfolios: 1,021,847; 
Enterprise 

purchases as a percentage of prior yearï¿½s portfolios: 50.78.



Year: 1994; Total enterprise purchases: 280,792; Total originations: 

773,121; Enterprise purchases as a percentage of originations: 36.32; 

Prior yearï¿½s total enterprise mortgage portfolios: 1,156,442; 
Enterprise 

purchases as a percentage of prior yearï¿½s portfolios: 24.28.



Year: 1995; Total enterprise purchases: 215,974; Total originations: 

639,436; Enterprise purchases as a percentage of originations: 33.78; 

Prior yearï¿½s total enterprise mortgage portfolios: 1,240,987; 
Enterprise 

purchases as a percentage of prior yearï¿½s portfolios: 17.40.



Year: 1996; Total enterprise purchases: 287,306; Total originations: 

785,329; Enterprise purchases as a percentage of originations: 36.58; 

Prior yearï¿½s total enterprise mortgage portfolios: 1,332,849; 
Enterprise 

purchases as a percentage of prior yearï¿½s portfolios: 21.56.



Year: 1997; Total enterprise purchases: 275,081; Total originations: 

859,100; Enterprise purchases as a percentage of originations: 32.02; 

Prior yearï¿½s total enterprise mortgage portfolios: 1,445,591; 
Enterprise 

purchases as a percentage of prior yearï¿½s portfolios: 19.03.



Year: 1998; Total enterprise purchases: 618,410; Total originations: 

1,470,000; Enterprise purchases as a percentage of originations: 42.07; 

Prior yearï¿½s total enterprise mortgage portfolios: 1,536,258; 
Enterprise 

purchases as a percentage of prior yearï¿½s portfolios: 40.25.



Year: 1999; Total enterprise purchases: 548,748; Total originations: 

1,275,000; Enterprise purchases as a percentage of originations: 43.04; 

Prior yearï¿½s total enterprise mortgage portfolios: 1,786,598; 
Enterprise 

purchases as a percentage of prior yearï¿½s portfolios: 30.71.



Year: 2000;  Total enterprise purchases: 395,082; Total originations: 

1,048,000; Enterprise purchases as a percentage of originations: 37.70; 

Prior yearï¿½s total enterprise mortgage portfolios: 2,062,943; 
Enterprise 

purchases as a percentage of prior yearï¿½s portfolios: 19.15.



Source: OFHEO.



[End of table]



At the end of 2001, Fannie Maeï¿½s total mortgage portfolio was $1.56 

trillion and Freddie Macï¿½s $1.14 trillion, of which $705 billion and 

$492 billion, respectively, represented on-balance sheet mortgages. For 

more information about the financial performance of the enterprises, 

see appendix II.



New Business Affects the Enterprisesï¿½ Level of Risk:



The enterprises face two primary risks, which are modeled in OFHEOï¿½s 

stress test: interest rate risk and credit risk. The degree of risk 

depends on the enterprisesï¿½ operating and managerial decisions as well 

as on future economic factors such as interest rates, unemployment, 

inflation, and economic growth. Although the enterprises can take risk-

management efforts to limit their exposure, the costs of these efforts 

can reduce profits. Thus, risk management is usually associated with 
both 

a lower expected or average profit and reduced variability in profits 
and 

losses.



Effects of Interest Rate Risk:



Interest rate risk reflects both movements in interest rates and 

management decisions about how to fund mortgage acquisitions. In 

general for the enterprises, when market interest rates decline, 

mortgage purchases increase as homeowners move and pay off or 

refinance existing mortgages. Declining rates may also lower the 

enterprisesï¿½ funding costs. In contrast, rising market interest rates 

create higher interest expenses for the enterprises as debt turns over. 

Prolonged periods of rising interest rates typically lead to a slowdown 

in prepayments and refinancing activity, because interest rates on new 

mortgages are higher than those on most of the previously originated 
mortgages. 

If funding costs rise and existing on-balance sheet mortgages at old, 

lower interest rates remain on the books, prolonged periods of losses 

and capital erosion can occur. Enterprise management can use callable 

debt [Footnote 12] and other financial instruments or strategies to 
mitigate interest 

rate risk and other potential losses. However, such managerial 
decisions 

will tend to lower future expected profits.



OFHEOï¿½s current stress test, which assumes no new business over a 10-

year period, simulates the impact of interest rate movements and 

economic conditions on the behavior of borrowers whose mortgages are 

held by the enterprises and therefore affect the enterprisesï¿½ cash 

flows. The model requires that the mortgage holdings wind down over the 

10-year period. The extent to which existing business winds down shows 

the importance of new business, because in practice the enterprises 

would be acquiring new mortgages to replace lost mortgages during the 

period.



In the stress test model, the remaining mortgage balance (and existing 

business) depends on scheduled payments of principal, other 

prepayments, and defaults. Prepayments are sensitive to interest rate 

changes because lower rates accelerate prepayments and higher rates 

depress them. Default losses are sensitive to economic conditions, 

including loan-to-value ratios and seasoning,[Footnote 13] because 
loans 

with lower loan-to-value ratios and seasoned loans are less likely to 

default.



OFHEO ran its model for us for a portfolio of newly originated 30-year 

fixed-rate single-family mortgages[Footnote 14] with 95 percent loan-

to-value ratios. About 4.7 percent of a portfolio of newly originated 

loans would still be on the enterprisesï¿½ books after 10 years in the 

declining interest rate environment mandated by the act. In the 

increasing rate environment mandated by the act, about 57.3 percent of 

a portfolio of newly originated loans would still be on the 

enterprisesï¿½ books after 10 years.[Footnote 15] OFHEO also ran the 

model on other portfolios with different loan-to-value ratios and 

degrees of seasoning, with similar results in both the declining and 

increasing rate environments. As previously stated, in actual practice 

the enterprises would replace many of the lost loans; and the types of 

mortgages acquired and types of financial instruments actually used to 

fund these new mortgages would significantly impact returns and risks.



Effects of Credit Risk:



Credit risk reflects both economic conditions and management decisions 

about mortgage acquisitions. Deteriorating economic conditions can 

lower home values and reduce homeownersï¿½ incomes, therefore increasing 

credit risk. Likewise, management decisions to increase loan-to-value 

ratios or otherwise ease underwriting standards can raise credit risk.



The OFHEO simulations also showed how the credit stresses in the 

mandated increasing and decreasing rate environments could affect 

credit-related losses. The simulations showed that, for a portfolio of 

newly originated single-family mortgages with a 95 percent loan-to-

value ratio, defaults would account for a decline of about 19.5 percent 

of the original mortgage balances in the decreasing rate environment 

and a decline of about 16.2 percent of the original mortgage balances 

in the increasing rate environment.



The enterprises could limit credit risk in several ways. For example, 

they could use more stringent underwriting standards, although such 

standards could limit the dollar volume of mortgages they are able to 

purchase and possibly affect their ability to support the residential 

mortgage market. For instance, requiring homeowners to make large down 

payments or purchase private mortgage insurance could make acquiring a 

mortgage more difficult for potential homeowners. Second, they could 

more aggressively monitor loans and work out problems with troubled 

loans. Third, the enterprises could mitigate the economic costs of 

defaults by raising the management guarantee fee they charge mortgage 

pools for providing credit insurance and managing the pools. 

Ultimately, however, management actions to limit credit risk might 

create expenses that would curtail expected future profits. Actual 

decisions about underwriting, mortgage monitoring, and guarantee fees 

would affect the returns and risks associated with the acquisition of 

new mortgages by the enterprises.



New Business Affects the Enterprisesï¿½ Capital Adequacy:



Under the risk-based capital test, capital adequacy measures the 

amount of capital an enterprise needs to ensure that it can continue 

to operate during a stressful period and is based on expected profits 

and the risks taken to generate those profits. Generally speaking, risk 

and profit are positively related. For example, an enterprise can 
increase 

its expected profits by taking more risks, but taking greater risks can 

increase the possibility that the enterprise will not survive a 
stressful 

economic period due to losses incurred. An enterprise can increase its 

chances of surviving a stressful period by increasing its capital 
level, 

but such increases raise funding costs and reduce future expected 
profits. 

Capital adequacy also depends on the extent and duration of the 
economic 

stress that the enterprise might encounter. The greater the levels of 
stress 

an enterprise must endure and the longer the exposure to stress, the 
less 

likely it is that the enterprise will survive the stress period with a 
given 

level of capital.



Incorporating New Business Assumptions Is Difficult and Inherently 

Speculative:



Incorporating new business assumptions into long-term financial 
planning 

models is difficult, primarily because doing so is inherently 
speculative. 

Incorporating such assumptions would require OFHEO to develop plausible 

scenarios for the future behavior of the enterprisesï¿½for example, the 
types 

of mortgages they might acquire, their future funding strategies, and 
other 

managerial decisions. In addition, OFHEO would have to consider HUDï¿½s 

regulatory actions and their effect on the enterprises during the 
stress 

period. The difficulty of incorporating new business assumptions into a 

stress test is reflected in the fact that the enterprises do not 
include 

such assumptions in their own long-term capital adequacy models. The 
enterprises 

generally use new business assumptions only in models with relatively 
short 

time frames (up to 4 years). Finally, OFHEOï¿½s stress test is already 
highly 

complex. Adding new business assumptions would increase its complexity 
and make 

the legal requirement that it be replicable more difficult to meet.



OFHEOï¿½s Assumptions about the Behavior of Management Would Be 

Speculative:



An OFHEO stress test with new business assumptions would have to 
include 

explicit assumptions about the enterprisesï¿½ strategic managerial 
behavior 

in a stressful economic environment. Managementï¿½s behavior would have 
to be 

linked to hedging, which affects interest rate risk; underwriting, 
which 

affects credit risk; and setting guarantee fees, which affect earnings. 

Specifying managementï¿½s behavior would be speculative, unlike the 
modeling 

of borrowersï¿½ behavior in the stress test. Borrowersï¿½ behavior related 
to 

mortgage prepayment and default can be and is predicted in the stress 
test, 

based on statistical techniques that are applied to historic data. 
Although 

this prediction is subject to statistical measurement errors, these 
techniques 

can be used to extrapolate borrower behavior in a stressful 
environment. 

However, because managerial behavior is idiosyncratic, such techniques 

cannot be used to extrapolate managerial behavior in a stressful 
environment 

from behavior in more normal economic environments. For instance, 
overall 

management strategies dealing with both interest rate and credit risks 

could either exacerbate risk exposures or mitigate such risks to 
various 

degrees. OFHEO would lack criteria, both statistical and theoretical, 
to 

justify assumptions about these strategies. Therefore, OFHEO would have 

to speculate about managerial behavior to develop new business 
assumptions. 

In addition, because a significant proportion of the enterprisesï¿½ 
mortgages 

either prepay or default over a 10-year period and are replaced by new 

business, the assumptions about new business could easily dominate the 

cash and capital flows in the stress test over the 10-year period. 
These 

assumptions could also determine whether the enterprises met or failed 
to 

meet the risk-based capital requirement.



In the legislative history of the act, Congress recognized that OFHEO 

would have to hypothesize about any new business assumptions that might 

be included in a stress test. Language in a Senate committee report 

explicitly recognized that incorporating new business assumptions 

during a stressful period would require speculating about enterprise 

behavior. The report recognized that any assumptions addressing new 

business in the stress test would also have to incorporate further 

assumptions about enterprise managementï¿½s capacity to make suitable 

adjustments.[Footnote 16]



The act requires the director to assume that the new business the 

enterprises conduct during the stress period will be consistent with 

either historic or recent experience and with the economic 

characteristics of the stress period. In particular, the director must 

make specific assumptions about five factors:



* the amounts and types of business,



* losses,



* pricing,



* interest rate risk, and:



* reserves.



These restrictions limit OFHEOï¿½s modeling assumptions, allowing for 

managerial response only after the advent of the stressful condition 

and requiring that the responses be consistent with the prior behavior 

of the enterprise. In other words, for purposes of the stress test 

OFHEO cannot assume that management will take actions in anticipation 

of stressful conditions, that management will be able to respond 

differently than it has previously under similar circumstances, or that 

management will respond promptly and effectively to stressful 

situations to maintain adequate capital.



OFHEO Would Need to Consider HUDï¿½s Regulatory Response to the 

Enterprisesï¿½ Housing Goals:



In addition to speculating about the behavior of the enterprisesï¿½ 

management, OFHEO would need to consider HUDï¿½s regulatory response to 

a stressful environment. HUD regulates the enterprises in terms of 

housing goals and other charter requirements not directly concerned 

with safety and soundness (see app. I for a detailed description of 

HUDï¿½s regulatory responsibilities and powers). [Footnote 17] However, 

when HUD establishes housing goals, it must look at several factors, 

including the need for the enterprises to remain in sound financial 

condition.



If either enterpriseï¿½s financial condition should falter, the Secretary 

of HUD would likely take regulatory actions to help the enterprise 

rather than allow it to withdraw entirely from the secondary mortgage 

market or from segments of the market governed by HUDï¿½s numeric goals. 

For modeling purposes, OFHEO would have to consider both the regulatory 

actions HUD might take to ensure that the enterprises continue to 

comply with the housing goals and the effects of such actions on 

managementï¿½s approach to new business and risks. HUDï¿½s regulatory 

response could have a further effect on the model by constraining the 

enterprises and thus affecting managerial decisions at the enterprises.



New Business Assumptions Are Not Included in Fannie Maeï¿½s Long-Term 

Financial Modeling or Freddie Macï¿½s Modeling for Capital Adequacy:



The enterprises do not include new business in their long-term 
financial 

models (Fannie Mae) or in their capital adequacy models (Freddie Mac) 
because 

they believe that such assumptions would be speculative. [Footnote 18] 
Fannie 

Mae officials told us that it would not be reasonable to make new 
business 

assumptions beyond a window of several years, and the results of such a 

modeling approach might be more reflective of the assumptions 
themselves 

than of the actual risks faced by Fannie Mae. Freddie Macï¿½s interest 
rate 

risk exposure is stated in terms of portfolio market value sensitivity, 

or the estimated percentage decline in Freddie Macï¿½s market value of 

equity that results from a change in interest rates. Freddie Mac 
officials 

told us that another reason they do not include new business in their 
risk 

models is that they want to focus on the risks of the current book of 

business and not the profitability of new business. Although OFHEO 
probably 

would not rely solely on the enterprisesï¿½ assumptions about new 
business, 

in the absence of such assumptions, OFHEO would still have to make 
plausible 

assumptions about the enterprisesï¿½ behavior.



The enterprises do include new business assumptions in the short-term 

models used to manage business on a day-to-day basis and for planning. 

The enterprisesï¿½ short-term planning models typically focus on business 

strategies during time periods of no more than 4 years under economic 

stresses that are relatively normal compared with those in OFHEOï¿½s 

stress test. Some of these models used to analyze interest rate risk 

include new business assumptions.



Other Entities Generally Do Not Incorporate New Business Assumptions 

When Evaluating Long-Term Capital Adequacy:



Our review of information from regulators and three rating agencies 
(Standard 

& Poorï¿½s, Moodyï¿½s, and Fitch) indicates that these entities do not use 
new 

business assumptions when evaluating the capital adequacy of financial 

institutions. For example, the Federal Housing Finance Board (FHFB) has 

issued risk-based capital standards for the other housing GSE, the 
Federal 

Home Loan Bank (FHLBank) System. FHFB developed an approach based on 
the 

existing balance sheet that estimates the market value of the FHLBankï¿½s 

portfolio at risk under financial stress scenarios and thus does not 

require an assumption about new business. As another example, 
depository 

institution regulators have established capital requirements for credit 

risk that assign all existing assets and off-balance sheet items to 
broad 

categories of relative risk; and they do not incorporate new business 
assumptions. 

In addition, Standard & Poorï¿½s, Moodyï¿½s, and Fitch use no new business 
in their 

stress tests for rating private mortgage insurers. [Footnote 19]



During our review, we identified one instance in which new business 

assumptions are included in a risk-based capital stress test. The Farm 

Credit Administration (FCA) has established risk-based capital 

standards for Farmer Mac, a relatively small GSE operating in the 

secondary market for agricultural mortgages. FCA includes replacement 

of paid-off agricultural mortgages in its 10-year stress test 

model.[Footnote 20]



Including New Business Assumptions Would Add Complexity to OFHEOï¿½s 

Stress Test and Make It Difficult to Replicate:



The unique nature of OFHEOï¿½s risk-based standard, particularly the 10-
year 

time frame and the specificity regarding stresses, makes the OFHEO 
stress 

test complex. Adding new business assumptions would increase this 
complexity 

by introducing more factors that could affect the behaviors modeled 
within 

the stress test and requiring that more behaviors be modeled. [Footnote 
21] 

Adding more complexity would further limit the ability of analysts and 
others 

to understand and replicate the test, as the 1992 act requires. 
[Footnote 22] 

For example, the test would likely require refinements to take into 
account the 

dynamic behaviors of borrowers, investors in enterprise debt and MBS, 
and the 

enterprises over the 10-year period. These behaviors include shifts in 
borrower 

demand for fixed- and adjustable-rate mortgages, investorsï¿½ willingness 
to take on 

the risk of alternative funding sources for the enterprises, and the 
enterprisesï¿½ 

mortgage purchase and funding strategies. According to enterprise 
officials, the 

ability of individuals outside of OFHEO to understand and replicate the 
current 

stress test is already strained, even without new business assumptions. 
The 

inclusion of new business assumptions to predict the behaviors of 
parties such 

as the mortgage originators, mortgage borrowers, investors, and the 
enterprises 

would exacerbate this situation.



New Business Assumptions Could Dominate the Capital Requirement Under 

the Stress Test:



To incorporate new business assumptions into its stress test, OFHEO 
could 

develop plausible scenarios for how enterprise management and the 
market might 

respond in a stressful environment, but depending on the assumptions, 
the 

capital requirement could be increased or decreased. The assumptions 
could 

dominate the capital requirement. In the early 1990s, for example, 
prior to 

the creation of OFHEO, HUD analyzed each enterpriseï¿½s capitalization 
using a 

stress test that incorporated a Depression scenario. [Footnote 23] 
HUDï¿½s analyses 

showed that incorporating new business resulted in higher capital 
requirements 

for the enterprises. HUD made two major assumptions that affected the 
result. 

First, HUD assumed that the enterprises would have difficulty 
determining 

exactly when a downturn would begin and projecting its length and 
severity. 

This assumption limited managementï¿½s ability to mitigate risk. Second, 
HUD 

assumed that the enterprises would be required to provide ongoing and 
meaningful 

support to the secondary mortgage market during a prolonged period of 
severe 

economic conditions; and therefore, the enterprises could not stop 
purchasing 

mortgages that might generate losses in a stressful environment.



Other plausible scenarios could lead to assumptions showing that 

incorporating new business might mitigate risk and improve capital 

adequacy. According to Fannie Mae officials, for example, including new 

business using the enterprisesï¿½ current underwriting standards and 

guarantee fees would result in a lower capital requirement. The 

officials pointed out that in a falling interest rate environment, the 

credit quality of an existing mortgage portfolio would typically 

decline as the less risky mortgages are refinanced and the more risky 

ones remain. Including new business that encompasses the newly 

refinanced mortgages would lower credit risk and thus result in a lower 

capital requirement. An alternative plausible set of assumptions 

showing that incorporating new business might mitigate risk and improve 

capital adequacy could presume that the enterprises would change their 

business practices to reduce risks in a stressful environment. For 

example, during a stressful period, the enterprises might implement 

stricter underwriting standards and increase their guarantee fees in 

reaction to possible declines in mortgage credit quality.



Supervisory Review Can Be Another Effective Tool for Limiting the 

Potential Risks of New Business:



While OFHEOï¿½s risk-based capital requirement is a key element in 
ensuring 

the enterprisesï¿½ financial safety and soundness, other mechanisms also 
exist 

to limit risk taking by the enterprises. The proposed Basle Accord 
revisions, 

which address banking supervision, list the three ï¿½mutually reinforcing 

pillarsï¿½ that help ensure the financial safety and soundness of banks. 
These 

pillarsï¿½risk-based capital requirements (discussed in this report), 
market 

discipline, and supervisory reviewï¿½ should also be used to address 
safety 

and soundness oversight of the enterprises. Based on our work on bank 
and 

GSE safety and soundness supervision and our review of the proposed 
Basle 

Accord revisions, we have concluded that capital regulation in 
isolation does 

not provide sufficient oversight.



Market discipline can curb risky behavior by the enterprises to the 

extent that the enterprisesï¿½ customers and creditors will demand that 

the enterprises stay fiscally strong in order to fulfill their 

obligations. Market discipline works best when firms fully and publicly 

disclose their financial conditions. Customers and creditors can then 

use the information to determine further interactions with the 

enterprises. In October 2000, the enterprises adopted six voluntary 

commitments aimed at increasing their disclosures. The commitments 

included, among other things, the issuance of subordinated debt and 

public disclosure of financial information. Enterprise officials stated 

that these commitments would improve transparency and market discipline 

because market participants could use the added information to better 

assess the financial condition of the enterprises. We acknowledge that 

financial disclosure as mandated by the voluntary accord may improve 

transparency. However, its impact on the enterprises and their 

customers or funding parties is limited if the enterprises are 

perceived to have implicit government backing. That is, other economic 

parties may believe that the federal government will ensure that the 

enterprises continue to operate and to perform satisfactorily on 

financial contracts such as loans and mortgage purchases. For this 

reason, while market discipline can play a role in curbing risky 

behavior by the enterprises, it also has its limitations. Supervisory 

review thus takes on more importance as a means for limiting 

inappropriate risk-taking behavior by the enterprises.



The proposed revision of the Basle Accord recognizes the supervisory 

review process as one of three ï¿½pillarsï¿½ that contribute to safety and 

soundness in the financial system. OFHEOï¿½s supervisory review includes 

examining the operations of the enterprises and taking the supervisory 

and enforcement actions necessary to ensure that the enterprises are 

operating safely and soundly. In conjunction with other elements of 

supervision, supervisory review can also help ensure that the 

enterprises maintain sufficient capital to support the risks they 

undertake. Further, it can encourage the enterprises to develop and use 

better risk-management techniques to address the risks associated with 

both existing and new business. Supervisory review can focus on 

internal approaches to capital allocation and internal assessments that 

reflect managementï¿½s own expectations about future business 

opportunities and risks without the need for OFHEO to impose its own 

assumptions about new business.



In addition, supervisory review allows OFHEO to address the 

enterprisesï¿½ management structure and business approaches to ensure 

that risk-management techniques and internal controls are appropriate 

and are protecting the public interest. Risk-management practices that 

sufficiently limit the credit and interest rate risks associated with 

new business and adequate OFHEO supervision of those practices can 

reduce the chances that an enterprise will take on risky new business 

that could jeopardize its capital adequacy in a stressful economic 

environment. For example, adequate supervision could inhibit an 

enterpriseï¿½s attempt to ï¿½growï¿½ its way out of a problem situation in a 

stressful environment by means such as lowering underwriting standards 

or relaxing risk-management controls that address interest rate risk. 

While adequate supervision is not guaranteed by the presence of OFHEO 

and its legal authorities, inclusion of speculative new business 

assumptions in the stress test--based on plausible managerial behavior-

-would not reduce the importance of adequate supervision.



OFHEO has several legal authorities that help in carrying out 

supervisory responsibilities relating to safety and soundness. These 

authorities include informal supervisory actions; formal enforcement 

actions involving notice to the affected enterprise; hearing 

opportunities; and, if warranted, imposition of sanctions such as cease 

and desist orders or civil monetary penalties. The Federal Deposit 

Insurance Corporation Improvement Act of 1991 mandates actions, known 

as prompt corrective actions (PCA), that depository institution 

regulators must take in response to specific capitalization levels. 

Similarly, the 1992 act contains PCA provisions that authorize and, 

depending on the level of undercapitalization, require OFHEO to take 

certain actions when an enterprise is undercapitalized.[Footnote 24] 

These mandates, which specify actions to be taken at certain levels of 

undercapitalization, limit the possibility that OFHEO might be lenient 

once an enterpriseï¿½s capital cushion is impaired. OFHEO has issued 

regulations implementing the PCA provisions and establishing prompt 

supervisory responses to be taken based on specified noncapital 

developments.[Footnote 25] The director of OFHEO has broad discretion 

over measures that can be taken beyond these required actions. Such 

discretionary powers allow the director of OFHEO to respond when 

specific enterprise practices occur that could pose a safety and 

soundness concern.



Conclusions:



Determining new business assumptions for inclusion in OFHEOï¿½s stress 
test 

is inherently speculative, and OFHEO would have to develop plausible 

scenarios for managerial behavior to make such a determination. The 

assumptions about new business could easily dominate the cash and 

capital flows over the 10-year stress test period and therefore 
dominate 

the capital requirement. Thus, these assumptions could also determine 

whether the enterprises met or failed to meet the risk-based capital 

requirement. Adding new business assumptions would introduce more 

complexity to an already complex model and interfere with the public 

policy mandate that requires the model to be understandable and 
replicable. 

A stress test that concentrates on existing business rather than 
potential 

new business allows all parties to observe the risks embedded in 
current 

holdings and operations. In addition, OFHEO can use supervisory review 

in conjunction with the stress test to help limit the potential risks 

associated with new business.



Recommendation:



OFHEO should not incorporate new business assumptions into its risk-

based capital stress test. Appropriate examination and supervisory 

review by the regulator can help ensure that the enterprises maintain 

capital appropriate to the financial stresses they are experiencing 

with regard to new business.



Agency Comments and Our Evaluation:



We requested comments on a draft of this report from the heads, or 
their 

designees, of Freddie Mac, Fannie Mae, and OFHEO. Freddie Macï¿½s written 

comments, which agreed with our conclusions and recommendation, appear 

in appendix III. Fannie Mae and OFHEO provided technical comments that 

were incorporated where appropriate. OFHEO officials also stated that 

OFHEO does not model or predict enterprise behavior in its current 

stress test, but does make assumptions to project enterprise behavior 

in a stylized way, consistent with the stress conditions. For example, 

they cited assumptions about enterprise new debt issues and operating 

expenses in the current stress test. Such assumptions, they stated, 

are necessary for a capital requirement that is appropriately sensitive 

to risk. The OFHEO officials stated that incorporating new business 

into the stress test would entail making assumptions that address 

additional complicated managerial decisions on the full range of 

enterprise activities. They added that, in contrast to the assumptions 

that project managerial behavior in the current stress test, the 

assumptions necessary to incorporate new business have the potential 

to unduly influence the capital requirement and make it less sensitive 

to current risks.



We made revisions based on OFHEOï¿½s comments distinguishing between 

modeling or predicting enterprise behavior and developing reasonable 

assumptions for enterprise management. We agree with OFHEO officials 

that, compared to the current stress test, incorporating new business 

into the stress test would require assumptions that address additional 

complicated managerial decisions on the full range of enterprise 

activities. Our report notes, in particular, that the assumptions 

required to incorporate new business could dominate the capital 

requirement.



We will send copies of this report to the Director of OFHEO, the Chief 

Executive Officer of Fannie Mae, and the Chief Executive Officer of 

Freddie Mac. We will also make copies available to others upon request.



Please contact William Shear or me at (202) 512-8678 if you or your 

staff have any questions concerning this report. Key contributors to 

this report were Mitchell Rachlis, Darleen Wall, Paul Thompson, and 

Emily Chalmers.



Thomas J. McCool

Managing Director

Financial Markets and

Community Investment:



Signed by Thomas J. McCool.



List of Congressional Committees:



The Honorable Paul S. Sarbanes

Chairman:

The Honorable Phil Gramm

Ranking Minority Member:

Committee on Banking, Housing,

 and Urban Affairs

United States Senate:



The Honorable Michael G. Oxley

Chairman:

The Honorable John J. LaFalce

Ranking Minority Member:

Committee on Financial Services

House of Representatives:



The Honorable Richard Baker

Chairman:

The Honorable Paul Kanjorski

Ranking Minority Member:

Subcommittee on Capital Markets, Insurance,

 and Government Sponsored Enterprises

Committee on Financial Services

House of Representatives:



[End of section]



Appendix I HUD Regulates the Enterprisesï¿½ Housing Goal Requirements:



Except for matters under the Office of Federal Housing Enterprise 

Oversightï¿½s (OFHEO) exclusive authority, which relate primarily to 

enterprise safety and soundness, the Secretary of the Department of 

Housing and Urban Development (HUD) has general regulatory power 

over the enterprises to ensure that they carry out the purposes of 

their charters. [Footnote 26] These purposes include (1) providing 

ongoing assistance to the secondary market for residential mortgages 

allowing for mortgages on housing for low- and moderate-income families 

involving lower returns than those earned on other activities and (2) 

promoting access to mortgage credit throughout the nation, including 

in central cities, rural areas, and underserved areas. Moreover, the 

act requires the Secretary to establish annual goals for the 

enterprisesï¿½ purchases of mortgages on low- and moderate-income 

housing; special affordable housing (housing for low-income families 

in low-income areas and for very low-income families); and housing 

in central cities, rural areas and other underserved areas. [Footnote 
27] 

Based on the regulatory scheme established in the act, the Secretary of 

HUD could exercise these authorities during a stressful period in 

a way that might affect an enterpriseï¿½s new business. For example, 

housing goals would require an enterprise to conduct new business. 

Forecasting these goals and the potential for other mission-related 

requirements and their impact on new business would be speculative.



The charter for each enterprise states that the purpose of the 

enterprise is:



* to provide stability in the secondary market for residential 

mortgages;



* to respond appropriately to the private capital market;



* to provide ongoing assistance to the secondary market for residential 

mortgages (including activities relating to mortgages on housing for 

low-and moderate-income families, involving a reasonable economic 

return that may be less than the return earned on other activities) by 

increasing the liquidity of mortgage investments and improving the 

distribution of investment capital available for residential mortgage 

financing; and:



* to promote access to mortgage credit throughout the nation (including 

central cities, rural areas, and underserved areas) by increasing the 

liquidity of mortgage investments and improving the distribution of 

investment capital available for residential mortgage financing.



The numeric goals provisions of the 1992 act require the Secretary to 

consider the following factors in setting final housing goals for each 

of the three categories of housing: (1) national housing needs; (2) 

economic, housing, and demographic conditions; (3) the performance and 

effort of the enterprises in achieving the goals in previous years; (4) 

the size of the conventional mortgage market serving targeted borrowers 

relative to the size of the overall conventional mortgage market; (5) 

the ability of the enterprises to lead the industry in making mortgage 

credit available to targeted borrowers; and (6) the need to maintain 

the sound financial condition of the enterprises.



Although the last factor requires consideration of an enterpriseï¿½s 

financial condition, nothing in the 1992 act suggests that the 

Secretary should refrain from establishing goals or taking other 

mission-related actions in the event of a stressful financial 

condition. However, we believe that the Secretary would not exercise 

mission and housing goal authorities in a way that would continue or 

increase an enterpriseï¿½s financial stress, because doing so would 

undermine the financial safety and soundness requirements of the 1992 

act and compromise the enterpriseï¿½s ability to achieve its 

mission.[Footnote 28]



[End of section]



Appendix II The Business of the Enterprises:



As table 2 shows, most of the enterprisesï¿½ on-balance sheet assets 

are mortgages. The table also shows that most of the mortgage and other 

on-balance sheet financial activities of the enterprises are funded by 

debt.



Table 2: Selected Enterprise On-Balance Sheet Holdings and Liabilities 

as of December 31, 2001:



Dollars in millions.



Item: Retained mortgage portfolio, net; Fannie Mae: $705,167; Freddie 

Mac: $491,719.



Item: Total assets; Fannie Mae: 799,791; Freddie Mac: 617,340.



Item: Debt, net; Fannie Mae: 763,467; Freddie Mac: 561,946.



Item: Total liabilities; Fannie Mae: 781,673; Freddie Mac: 601,967.



Item: Stockholders equity capital; Fannie Mae: 18,118; Freddie Mac: 
15,373.



Sources: Enterprise Investor/Analyst Reports.



[End of table]



Each enterpriseï¿½s total mortgage portfolio (see table 3) consists of 

on-balance sheet mortgages and mortgage-backed securities (MBS) held by 

the enterprises, and off-balance sheet MBS owned by investors who 

receive their interest and principal from a pool of mortgages. At the 

end of 2001, Fannie Maeï¿½s total mortgage portfolio was $1.56 trillion, 

and Freddie Macï¿½s was $1.14 trillion. A majority of the enterprisesï¿½ 

holdings consisted of off-balance sheet MBS pools. Over time, both 

enterprises have shifted a greater share of their mortgage assets on 

book, increasing their interest rate risk.



Table 3: Total Mortgage Portfolio of the Enterprises, Year-End 2001:



Dollars in millions.



Mortgage assets, including MBS, on the balance sheet; Fannie Mae: 

$705,167; Freddie Mac: $491,719.



Item: Mortgage-backed securities held by the public; Fannie Mae: 

858,867; Freddie Mac: 646,448.



Item: Total mortgage portfolio; Fannie Mae: 1,564,034; Freddie Mac: 

1,138,167.



Source: Enterprise Investor/Analyst Reports.



[End of table]



The enterprisesï¿½ income and expenses reflect their basic operations. 

Fannie Maeï¿½s 2001 net income was $5.9 billion and Freddie Macï¿½s $4.1 

billion, largely from net interest and fee income (see table 4). 

Mortgages and MBS owned by the enterprises generated net interest 

income of $8.1 billion for Fannie Mae and $5.5 billion for Freddie Mac, 

while investor-owned MBS generated fee income that totaled about $1.6 

billion for each enterprise. Actual and estimated expenses related to 

credit risk were $77.7 million for Fannie Mae and $84 million for 

Freddie Mac, while administrative expenses were about 17 percent of net 

income for both enterprises.



Table 4: Selected Data on Enterprise Income and Expenses for the year 

ending December 31, 2001:



Dollars in millions.



Item: Net income; Fannie Mae: $5,894.1; Freddie Mac: $4,147.



Item: Guarantee fees and other fee income; Fannie Mae: 1,633.4; Freddie 

Mac: 1,639.



Item: Net interest income; Fannie Mae: 8,090.1; Freddie Mac: 5,480.



Item: Provision for losses; Fannie Mae: 115; Freddie Mac: (45).



Item: Estimated losses due to foreclosures; Fannie Mae: (192.7); 
Freddie 

Mac: (39).



Item: Administrative expenses; Fannie Mae: (1,017.6); Freddie Mac: 
(844).



Source: Enterprise Investor/Analyst Reports.



[End of table]



[End of section]



Appendix III Comments from Freddie Mac:



Freddie Mac: We Open Doors:



Edward L. Golding, Senior Vice President:

Housing Economics & Financial Research: 

(703) 903-23707:

Fax (703) 903-4077:

Email: [email protected]:



8200 Jones Beach Drive, Mailstop 486: 

McLean, VA 22102-3310:



June 3, 2002: 



Mr. Thomas J. McCool, Managing Director: 

Financial Markets and Community Investment:

U.S. General Accounting Office: 

Washington, D.C. 20410:



Dear Mr. McCool:



Thank you for giving us the opportunity to review GAOï¿½s draft report, 

OFHEOï¿½s Risk-Based Capital Stress Test: Incorporating New Business is 
Not 

Advisable. We also appreciate the opportunity to meet with GAO staff 
during 

their preparation of the report to offer our perspective on this issue.



Freddie Mac agrees with GAOï¿½s conclusion that the Office of Federal 
Enterprise 

Housing Oversight (OFHEO) should not incorporate new business 
assumptions into 

its risk-based capital stress test. We agree with GAO that determining 
the 

assumptions is inherently speculative and that introducing them would 
increase 

the complexity of the stress test and reduce its transparency by making 
it more 

difficult to understand. In addition, we agree that supervisory review 
of OFHEO 

should work in conjunction with the capital standards to help ensure 
Freddie 

Macï¿½s safety and soundness. 



Please contact me if you have any questions of if we may be of further 
assistance. 



Sincerely,



Edward Golding, Senior Vice President:

Housing Economics and Financial Research:



Signed by Edward Golding. 



[End of Section]



Related GAO Products:



Federal Home Loan Bank System: Establishment of a New Capital 
Structure. 

GAO-01-873. Washington, D.C.: July 20, 2001. 



Comparison of Financial Institution Regulatorsï¿½ Enforcement and Prompt 

Corrective Action Authorities. GAO-01-322R. Washington, D.C.: January 

31, 2001.



Capital Structure of the Federal Home Loan Bank System. GAO/GGD-99-

177R. Washington, D.C.: August 31, 1999.



Farmer Mac: Revised Charter Enhances Secondary Market Activity, but 

Growth Depends on Various Factors. GAO/GGD-99-85. Washington, D.C.: May 

21, 1999.



Federal Housing Finance Board: Actions Needed to Improve Regulatory 

Oversight. GAO/GGD-98-203. Washington, D.C.: September 18, 1998.



Federal Housing Enterprises: HUDï¿½s Mission Oversight Needs to Be 

Strengthened. GAO/GGD-98-173. Washington, D.C.: July 28, 1998.



Risk-Based Capital: Regulatory and Industry Approaches to Capital and 

Risk. GAO/GGD-98-153. Washington, D.C.: July 20, 1998.



Government-Sponsored Enterprises: Federal Oversight Needed for 

Nonmortgage Investments. GAO/GGD-98-48. Washington, D.C.: March 11, 

1998.



Federal Housing Enterprises: OFHEO Faces Challenges in Implementing a 

Comprehensive Oversight Program. GAO/GGD-98-6. Washington, D.C.: 

October 22, 1997.



Government-Sponsored Enterprises: Advantages and Disadvantages of 

Creating a Single Housing GSE Regulator. GAO/GGD-97-139. Washington, 

D.C.: July 9, 1997.



Housing Enterprises: Investment, Authority, Policies, and Practices. 

GAO/GGD-91-137R. Washington, D.C.: June 27, 1997.



Comments on ï¿½The Enterprise Resource Bank Act of 1996.ï¿½ GAO/GGD-96-

140R. Washington, D.C.: June 27, 1996.



Housing Enterprises: Potential Impacts of Severing Government 

Sponsorship. GAO/GGD-96-120. Washington, D.C.: May 13, 1996.



Letter from James L. Bothwell, Director, Financial Institutions and 

Markets Issues, GAO, to the Honorable James A. Leach, Chairman, 

Committee on Banking and Financial Services, U.S. House of 

Representatives, Re: GAOï¿½s views on the ï¿½Federal Home Loan Bank System 

Modernization Act of 1995.ï¿½ B-260498. Washington, D.C.: October 11, 

1995.



FHLBank System: Reforms Needed to Promote Its Safety, Soundness, and 

Effectiveness. GAO/T-GGD-95-244. Washington, D.C.: September 27, 1995.



Housing Finance: Improving the Federal Home Loan Bank Systemï¿½s 

Affordable Housing Program. GAO/RCED-95-82. Washington, D.C.: June 9, 

1995.



Government-Sponsored Enterprises: Development of the Federal Housing 

Enterprise Financial Regulator. GAO/GGD-95-123. Washington, D.C.: May 

30, 1995.



Farm Credit System: Repayment of Federal Assistance and Competitive 

Position. GAO/GGD-94-39. Washington, D.C.: March 10, 1994.



Farm Credit System: Farm Credit Administration Effectively Addresses 

Identified Problems. GAO/GGD-94-14. Washington, D.C.: January 7, 1994.



Federal Home Loan Bank System: Reforms Needed to Promote Its Safety, 

Soundness, and Effectiveness. GAO/GGD-94-38. Washington, D.C.: 

December 8, 1993.



Improved Regulatory Structure and Minimum Capital Standards are Needed 

for Government-Sponsored Enterprises. GAO/T-GGD-91-41. Washington, 

D.C.: June 11, 1991.



Government-Sponsored Enterprises: A Framework for Limiting the 

Governmentï¿½s Exposure to Risks. GAO/GGD-91-90. Washington, D.C.: May 

22, 1991.



Government-Sponsored Enterprises: The Governmentï¿½s Exposure to Risks. 

GAO/GGD-90-97. Washington, D.C.: August 15, 1990.



[End of Section]



FOOTNOTES



[1] P. L. No. 102-550, title XIII (1992). The mandate is codified at 12 

U.S.C. ï¿½ 4611 (a)(3)(C) (2000).



[2] The level of risk-based capital a regulated institution is required 

to hold is based on potential losses the institution faces as a result 

of its activities.



[3] 12 C.F.R. part 1750 (2002).



[4] The Congressional Budget is also required to submit an opinion.



[5] The enterprisesï¿½ charters restrict them to buying mortgages that do 

not exceed a set dollar amount. This ceiling is known as the conforming 

loan limit. 



[6] For financial purposes, capital is generally defined as the long-

term funding for a firm that cushions the firm against unexpected 

losses. 



[7] Generally, credit risk is the risk of loss that arises when 

borrowers fail to repay their loans, other parties fail to meet their 

obligations to administer or guarantee loans, or both. 



[8] Generally, interest rate risk is the exposure to possible losses 
and 

changes in value arising from changes in interest rate.



[9] Generally, management and operations risk is the exposure to 

financial loss from inadequate systems, management failure, faulty 

controls, or human error.



[10] Due to data limitations, we compared enterprise purchases with 
total 

single-family originations.



[11] An enterpriseï¿½s total mortgage portfolio includes on-balance 
mortgage 

assets plus off-balance sheet MBS held by investors. MBS issuance moves 

mortgage assets and associated interest-rate risk off the enterpriseï¿½s 

balance sheet unless the enterprise repurchases the securities. 



[12] Callable debt refers to financial debt instruments, such as bonds, 

that are redeemable by the issuer before the scheduled maturity. The 
issuer 

must pay the holders a premium price if such a security is retired 
early. 

Bonds are usually called when interest rates fall so significantly that 

the issuer can save money by floating new bonds at lower rates. 



[13] The act defines seasoning as ï¿½the change over time in the ratio of 

the unpaid principal balance of a mortgage to the value of the property 

by which such mortgage loan is secured.ï¿½ 12 U.S.C. ï¿½ 4611 (d)(1) 

(2000).



[14] A single-family mortgage loan finances a one-to four-unit 

residential property; multifamily loans finance properties with five or 

more housing units. 



[15] Part of this decline in mortgage balances is the result of factors 

such as defaults. 



[16] S. Rep. No. 102-282 at 22 (1992). 



[17] The act gave the Secretary of HUD exclusive authority to 
promulgate 

numeric housing goals for the enterprises and to monitor and enforce 

compliance with these goals. 



[18] Fannie Mae officials distinguish between long- and short-term 
models, 

with long-term models covering periods of more than 4 years. Freddie 
Mac 

officials distinguish between capital adequacy (or risk) models and 
models 

used to manage day-to-day business (and for planning).



[19] The enterprises face credit risks that are similar to those faced 
by 

private mortgage insurance companies. 



[20] Requirements for the test can be found at 12 C.F.R. part 650 

(2002). We did not evaluate FCAï¿½s stress test. 



[21] Under the act, the director of OFHEO, among other considerations, 

is required to ensure that the regulations ï¿½shall contain specific 
requirements, 

definitions, methods, variables and parameters used under the risk-
based capital 

test and in implementing the test (such as loan loss severity, float 
income, 

loan-to-value ratios, taxes, yield curve slopes, default experience, 
and prepayment 

rates).ï¿½ 12 U.S.C. ï¿½ 4611 (e)(2) (2000). 



[22] The act requires OFHEOï¿½s risk-based capital regulations to be 
ï¿½sufficiently 

specific to permit an individual other than the director to apply the 
test in 

the same manner as (OFHEO).ï¿½ 12 U.S.C. ï¿½ 4611 (e)(2) (2000).



[23] Capitalization Study of the Federal National Mortgage Association 
and the 

Federal Home Loan Mortgage Corporation (November 1991); 1991 Report to 
Congress 

on the Federal Home Loan Mortgage Corporation (December 1992); 1991 
Report to 

Congress on the Federal National Mortgage Association (December 1992). 



[24] See U.S. General Accounting Office, Comparison of Financial 

Institution Regulatorsï¿½ Enforcement and Prompt Corrective Action 

Authorities, GAO-01-322R (Washington, D.C.: Jan. 31, 2001). Unlike 

other depository institution regulators, OFHEO lacks the authority to 

remove officers and directors, place an enterprise into receivership, 

or bring suit on the agencyï¿½s behalf (OFHEO must rely on the Attorney 

General). 



[25] On January 25, 2002, OFHEO published regulations on prompt 

supervisory response and corrective action. The regulations contain the 

procedures under which OFHEO is to take prompt corrective action in 

response to specified declines in enterprise capital levels and 

contains a system of prompt supervisory responses to be taken when 

specified developments internal or external to an enterprise warrant 

special supervisory review. 67 Fed. Reg. 3587 (Jan. 25, 2002). 



[26] The act directs the Secretary to exercise this authority by 
issuing 

the rules and regulations necessary and proper to ensure that the 
purposes 

of the enterprisesï¿½ charter acts are accomplished. 12 U.S.C. ï¿½ 4541 
(2000).



[27] Federal Housing Enterprises Financial Safety and Soundness Act of 
1992, 

P. L. No. 102-550, title XIII, 106 stat. 3672, 3941. HUD currently has 
numeric 

goals in place for the years 2001 through 2003. For example, the low- 
and 

moderate-income goal is set at 50 percent of each enterpriseï¿½s mortgage 

purchases, an increase from the 42-percent requirement set for the 
years 

1997 through 1999.



[28] The act contains provisions authorizing, and in some circumstances 

requiring, OFHEO to take supervisory and/or enforcement actions based 

on the degree to which an enterprise is undercapitalized. See 12 U.S.C. 

ï¿½ï¿½ 4614-4636 (2000). 



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