[Federal Register Volume 66, Number 243 (Tuesday, December 18, 2001)]
[Proposed Rules]
[Pages 65146-65162]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-30898]
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DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT
Office of Federal Housing Enterprise Oversight
12 CFR Part 1750
RIN 2550-AA23
Risk-Based Capital
AGENCY: Office of Federal Housing Enterprise Oversight, HUD.
ACTION: Proposed regulation.
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SUMMARY: The Office of Federal Housing Enterprise Oversight (OFHEO) is
proposing to amend Appendix A to Subpart B of 12 CFR Part 1750 Risk-
Based Capital. The effect of these amendments would be to modify
provisions relating to counterparty haircuts, multifamily loans, and
refunding and to make several technical
[[Page 65147]]
adjustments and corrections. These amendments are intended to refine
the stress test model to tie capital more closely to risk.
DATES: Written comments must be received by January 17, 2002.
ADDRESSES: Send written comments concerning the proposal to Alfred
Pollard, General Counsel, Office of Federal Housing Enterprise
Oversight, Fourth Floor, 1700 G Street, NW., Washington, DC 20552.
Written comments may also be sent to Mr. Pollard by electronic mail at
[email protected]. OFHEO requests that written comments submitted
in hard copy also be accompanied by the electronic version in MS Word
or in portable document format (PDF) on 3.5" disk.
FOR FURTHER INFORMATION CONTACT: Edward J. Szymanoski, Acting
Associate Director, Office of Risk Analysis and Model Development,
telephone (202) 414-3763 (not a toll-free number), or David Felt,
Associate General Counsel, telephone (202) 414-3750 (not a toll-free
number), Office of Federal Housing Enterprise Oversight, Fourth Floor,
1700 G Street, NW., Washington, DC 20552. The telephone number for the
Telecommunications Device for the Deaf is (800) 877-8339.
SUPPLEMENTARY INFORMATION:
Comments
The Office of Federal Housing Enterprise Oversight (OFHEO) invites
comments on the proposed regulation and will take all comments into
consideration before issuing the final regulation. Copies of all
comments will be posted on the OFHEO internet web site at http://www.ofheo.gov. In addition, copies of all comments received will be
available for examination by the public at the Office of Federal
Housing Enterprise Oversight, Fourth Floor, 1700 G Street, NW.,
Washington, DC 20552.
Background
On September 13, 2001, OFHEO published a final regulation setting
forth a risk-based capital stress test, (Rule) \1\ that is the basis
for determining the risk-based capital requirement for the Federally
sponsored housing enterprises--Federal National Mortgage Association
(Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac)
(collectively, the Enterprises). The risk-based capital stress test set
forth in the Rule simulates the performance of each Enterprise's
assets, liabilities, and off-balance-sheet obligations under severe
credit and interest rate stress for a period of ten years (stress
period). The stress test projects rates of default and prepayment for
the mortgages guaranteed by the Enterprises, as well as cash flows from
these and other assets, liabilities, and off-balance-sheet obligations.
Using these cash flows, the stress test produces monthly balance sheets
for the 120 months of the stress period in order to determine the
amount of starting capital that would be necessary to maintain positive
capital during the ten-year stress period. Thirty percent of the amount
of capital so determined is then added to that amount to protect
against management and operations risk.
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\1\ Risk-based Capital, 66 FR 47730 (September 13, 2001).
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OFHEO continuously seeks to improve its measurements and formulas
to tie capital more closely to risk and works to ensure that the Rule
supports the safety and soundness regime created by Congress. In the
preamble to the Rule, OFHEO expressed its intention to review, on an
ongoing basis, the operation of the stress test and its various
components and to evaluate the need for revisions and improvements.
Also, OFHEO committed to act expeditiously to remedy any technical and
operational issues that arise during the one-year implementation period
following promulgation. OFHEO is now proposing to make refinements and
technical adjustments and corrections to the Rule to tie capital more
closely to risk. Technical changes are included in this proposal rather
than issued as a final regulation to provide a comprehensive package of
changes.
A. Proposed Changes to Counterparty Haircuts
The Rule gives the Enterprises credit for cash payments that would
be received during the stress period from securities and various
counterparties, such as mortgage insurance companies and derivative
counterparties. However, because Enterprise counterparties are
themselves likely to be adversely affected by the economic conditions
of the stress period and to default on some or all of their
obligations, the stress test discounts the value of cash payments
received during the stress period by a specified percentage, based on
the public credit rating of the security or counterparty. The amount by
which cash payments from a counterparty or security are discounted in
each month of the stress period is the haircut. The specified haircut
percentages increase as the credit rating declines--the lower that
rating, the more severe the haircut. In the Rule, the haircuts are
phased in over the first five years of the stress period, except for
haircuts for below-investment-grade providers and instruments, which
are applied fully in the first month of the stress period.
The Rule applies one set of haircuts for non-derivative
counterparties and securities, based on analysis of historical bond
default rates, and a different set of haircuts for derivative
counterparties, reflecting lower expected loss severities associated
with the use of strong collateral agreements. To further refine the
Rule's treatment of haircuts, OFHEO proposes to improve consistency
between haircuts for derivative counterparties and securities and non-
derivative counterparties and securities by specifying default and
severity rates separately; to extend the phase-in period from five to
ten years; to provide for netting of exposures to the same derivative
counterparty; and to provide for an exception to the BBB haircut for
certain unrated seller/servicers as described in the proposed rule.
Default Rates. OFHEO proposes to use the Rule's haircut rates for
non-derivative counterparties and securities as the cumulative default
rates for all counterparties and securities, but to lower slightly the
default rate for AA-rated firms. After re-evaluating the historical
data on differences in performance of AA-rated and AAA-rated firms,
including data that recently has become available to OFHEO, the Rule's
default ratio of three to one (based largely on the average exposure
over the past 80 years) appears to be more than is warranted for a
period of economic stress. Data were recently made available to OFHEO
by Moody's Investors Service \2\ for the worst annual cohorts of U.S.
investment-grade issuers since 1920, the cohorts formed at the
beginning of 1929, 1930, and 1931. The average 10-year default rate for
AA-rated issuers (12.25 percent) was 2.6 times as large as the average
default rate for AAA-rated issuers (4.72 percent), and the ratio for
the worst of those years was only 2.2. Furthermore, a study of
corporate bond quality by W. Braddock Hickman shows 12-year default
rates for the cohort formed at the beginning of 1928 for AA-rated
issuers (12.3 percent) to be 1.5 times as large as that for AAA-rated
issuers (8.1 percent).\3\ More recent data, in relatively favorable
economic
[[Page 65148]]
circumstances, also show greater similarity in the performance of
issuers in these two rating categories. However, a partially offsetting
factor is that Moody's data for both depression cohorts and averages of
all cohorts show that defaults of AAA-rated issuers that occur within
10 years after the cohort is formed occur later in the 10-year period
than those of AA-rated issuers.
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\2\ For purposes of this proposal, Moody's Investors Service
provided information on ``Letter Cumulative Default Rates (from 01/
01/29 to 01/01/31)'' on October 16, 2001. Data may be obtained from
Moody's Investors Service by contacting Mr. Steve Liebling at
Liebling@Moody's.com.
\3\ W. Braddock Hickman, ``Corporate Bond Quality and Investor
Experience,'' 190 National Bureau of Economic Research (1958).
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The relationship between AA and AAA defaults is particularly
relevant because most Enterprise counterparty and security exposures
are either AAA-or AA-rated. An excessive differential between these
ratings in the stress test could create inappropriate business
incentives for the Enterprises. After weighing the above
considerations, OFHEO proposes to lower the cumulative default rate for
AA-rated counterparties and securities to 12.5 percent (from 15
percent), which will be 2.5 times the rate for AAA-rated counterparties
and securities.
Severity Rates. To further refine risk measurement in the stress
test, OFHEO proposes to take explicit account of potential recoveries
in the event of default by introducing a loss severity factor. Before
issuing the Rule, OFHEO received mixed comments regarding incorporation
of recovery projections for non-derivative security and counterparty
obligations after default. Such recoveries were not part of the
proposed rule, however, and OFHEO decided not to include them at that
time, pending further consideration. Historically, corporate bond
recoveries have averaged about 40 percent (i.e., a 60 percent loss
severity rate) over long periods of time. A study of default and
recovery rates by Moody's shows an average recovery rate of 39 percent
over the past 20 years.\4\ A study of defaulted bond recoveries by
Standard and Poor's shows an average recovery rate of 44 percent from
1981 to 1997.\5\ The Hickman study shows an average recovery rate of 43
percent for large issues from 1900 to 1943.\6\ Recoveries on Enterprise
holdings of mortgage and other asset-backed securities and on mortgage
insurance claims would likely be substantial also, benefiting from
asset values in the former case and premium income in the latter.
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\4\ ``Default Recovery Rates of Corporate Bond Issues: 2000,''
26 Moody's Investor's Service (February 2001).
\5\ ``Ratings Performance 1997: Stability of Transition,'' 3
Standard and Poor's (August 1998).
\6\ Hickman, at 460.
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Data on recoveries in unusually stressful times are less favorable.
Hickman reported an average recovery rate of 34 percent for large
issues for defaults in 1930 to 1943.\7\ Moody's has reported average
recovery rate estimates that are substantially lower during recessions,
and fall as low as 20 percent during the 1930s.\8\ For 1930 to 1943,
Moody's average was 36 percent, despite higher rates during the latter
years of that period. A somewhat lower projection for the stress period
used in the rule is, therefore, appropriate.
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\7\ Hickman, at 119.
\8\ ``Historical Default Rates of Corporate Bond Issuers, 1920-
1996,'' 12 Moody's Investor Service (January 1997).
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All of the recovery studies show some differences in recovery rates
depending on the presence or absence of secured or subordinated status.
However, such status is a factor used in determining ratings. Moody's
expressly states that securities with different status may have similar
probabilities of default, but be rated differently in recognition of
the effect of security or subordination on likely recoveries.\9\ Thus,
a secured instrument may have a somewhat higher probability of default
than average for its rating, but also have a somewhat higher
expectation of recovery. Accordingly, OFHEO proposes to specify a
recovery rate of 30 percent (70 percent loss severity rate) for all
non-derivative counterparties and securities with investment-grade
ratings.
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\9\ Moody's (2001), at 24-25.
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OFHEO also proposes to maintain, with alteration, special treatment
for derivative counterparty exposures. Current exposures are marked to
market at least weekly, and high quality collateral is posted against
any significant exposures by counterparties with less than a AAA
rating. The Enterprises retain the right to require substantial over-
collateralization or to transfer the contract to a new counterparty if
a counterparty's rating is lowered to low investment-grade levels or
worse. Thus, the principal risk is that a relatively highly rated
counterparty may fail suddenly and that exposures rise between the time
a contract was last collateralized and the time the Enterprise takes
action to transfer or replace the contract. This period may be as much
as ten business days.
The credit exposures on fixed-floating interest rate swaps and
swaptions (the vast majority of Enterprise derivative contracts) are
closely tied to changes in market yields of securities with maturities
equal to those of the swap or swaptions. When interest rates rise, an
Enterprise's exposure rises on swaps for which it receives the
floating-rate side of the swap. When interest rates fall, an
Enterprises's exposure rises on swaps for which it receives the fixed-
rate side.
To develop loss severity rates for defaulted derivative contracts,
OFHEO examined changes in Treasury security interest rates over periods
of ten business days during the past 25 years. For five-year Treasury
securities, increases in yields of more than 7.5 percent and decreases
of more than 5.0 percent, respectively, have occurred infrequently-
roughly 1 percent and 4 percent, respectively, of the time.\10\ Thus,
severity rates that reflect losses associated with yield changes of
these magnitudes should be reasonably conservative.
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\10\ These percentages correspond to absolute changes of 61 and
41 basis points, on average, during the period, but would be less
than half as much at recent yield levels.
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For application in the stress test's cash flow model, OFHEO must
translate such changes into impacts on net derivative cash flows.
During the stress period, net derivative cash flows are related to
changes in the ten-year Treasury yield-75 percent in the up-rate
scenario and 50 percent in the down-rate scenario. For example, in the
up-rate scenario, with its flat yield curve, the pay side of a ten-year
pay-fixed/receive-floating swap implemented just before the start of
the stress test would remain at its original rate and the receive side
would rise to 175 percent of the original pay-side rate. Thus, the swap
would have net annual cash flows for the last nine years of the stress
test roughly equal to 75 percent of the initial fixed rate used in the
swap multiplied by the notional value. This is ten times the 7.5
percent market yield change that may be associated with losses on a
derivative counterparty default in the up-rate scenario. Accordingly,
OFHEO proposes to set severity rates for derivative exposures at ten
percent.\11\
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\11\ Loss severities of counterparty defaults are typically
expressed as percentages of derivative market value at the time of
default. However, the stress test model reflects such losses as
reductions in net derivative cash flows. For example, in the up-rate
stress scenario, after a 75 percent increase in interest rates, a
swap with a market value of zero at the start of the stress test
(i.e., a fixed-pay rate equal to the then-market rate) will have a
significantly increased market value during the stress period. Since
short- and long-term rates are the same in the last nine years of
the stress period in the up-rate scenario, net derivative cash flows
roughly equal the scenario-based change in long-term interest rates
multiplied by the notional value, and the market value of the swap
is the discounted present value of these cash flows. A ten percent
reduction in those cash flows thus reflects the impact on market
value of a 7.5 percent change in interest rates.
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OFHEO recognizes that losses could be greater than ten percent if
interest rates move exceptionally after a sudden default, or if an
Enterprise failed to replace a contract with a defaulting counterparty
and market yields
[[Page 65149]]
continued to move unfavorably. However, OFHEO also recognizes that
yield changes near the time of a default could easily be less
unfavorable than the 7.5 percent increase or 5 percent decrease
contemplated, and some recoveries beyond the collateral already held
might be available. Thus, OFHEO judges that a ten percent severity rate
for derivatives is adequate.
Haircuts. Under the proposal, haircuts would be determined by
multiplying the default rate for each rating category by the severity
rate. The resulting haircuts that are proposed are set forth in Table 1
below.
Table 1--Stress Test Haircut by Ratings Classification
------------------------------------------------------------------------
Non-Derivative
Derivative Contract
Ratings Classification Contract Counterparties
Counterparties or Instruments
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Cash 0% 0%
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AAA 0.5% 3.5%
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AA 1.25% 8.75%
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A 2% 14%
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BBB 4% 28%
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Below BBB and Unrated 100% 100%
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Phase-In. Under the Rule, haircuts for investment-grade
counterparties and securities are phased-in over the first five years
of the stress period, so that haircuts are close to zero in the first
month of the stress period and rise to their maximums in the 60th
month, where they remain for the last five years. In effect, all
defaults occur within the first five years, and later haircuts to cash
flows simply reflect the consequences of previous defaults, as
defaulted counterparties are unable to meet their obligations. This
conservative approach takes into account that the interest rate shocks
and house price shocks all occur in the first half of the stress
period. Long-term average historical data show more evenly distributed
defaults over time, but available data for especially stressful periods
(e.g., the 1910s and 1930s) give little indication of timing. The
recently obtained unpublished data from Moody's shows that for the
worst cohort (starting in the beginning of 1930), only 57 percent of
ten-year investment-grade defaults occurred during the first five
years. While the principal shocks may occur somewhat earlier in the
stress period than they did for issuers in the 1930s, a closer
approximation of the historical patterns may better reflect the ability
of most highly rated firms to survive severe stresses for many years.
Some of those that ultimately fail during the stress period may
reasonably be expected to fail during its final years. Accordingly,
OFHEO proposes to extend the phase-in period from five years to ten
years for investment-grade counterparties and securities. Thus, for
credit exposures to firms and securities rated BBB and higher, defaults
will occur evenly throughout the stress period.
Netting of derivative counterparty exposures. The Enterprises
regularly enter into derivatives contracts, typically swaps, for debt
and portfolio risk management purposes. These contracts expose the
Enterprises to the risk of failure by a derivative counterparty to
perform its obligations as anticipated by the terms of the contract.
The Enterprises, consistent with accepted risk management and market
practice, attempt to mitigate their derivative counterparty credit
exposure through a number of methods, including the use of master
netting agreements. Master netting agreements are used by the
Enterprises when they engage in multiple swap transactions with the
same counterparty. A master netting agreement permits an Enterprise to
determine its aggregate total credit exposure to a particular
counterparty by netting the gains and losses across all of the
contracts with that counterparty. This approach allows the Enterprises
to net their exposures at the counterparty level, rather than netting
at the individual contract level.
In NPR2, OFHEO proposed a methodology to recognize this practice by
modeling the terms of master netting agreements and then applying
specified haircuts to the resulting net amount due, if any, from each
derivatives counterparty.\12\ No comments were received on the
proposal, and the Rule, reflecting OFHEO's intent to model master
netting agreements, did not specify a change from NPR2. However, due to
a technical omission, OFHEO's intent to model master netting agreements
was not operationalized in the Rule. Recognition of master netting
agreements would result in a more accurate measurement of the
Enterprises' exposure to derivative counterparties. Further,
recognition of master netting agreements is consistent with OFHEO's
intent to model Enterprise contracts according to their respective
terms, and such recognition allows OFHEO to tie capital to risk with
greater precision. The proposal would amend the Rule to model master
netting agreements explicitly, as originally contemplated in NPR2.
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\12\ NPR2 refers to the Second Notice of Proposed Rulemaking
issued by OFHEO before the Rule. 64 FR 18084, 18159 (April 13,
1999).
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OFHEO notes that this technical correction will require an
implementation period to allow for development and completion of the
software changes that will allow OFHEO to model master netting
agreements. Therefore, during the implementation of the technical
correction, OFHEO will recognize the risk mitigation effects of such
agreements by reducing the haircuts for derivatives contracts. Upon
implementation of the technical correction, maximum haircuts for
derivative contract counterparties will be readjusted and netting by
counterparty will be implemented in the software. The interim treatment
will remain effective only for the period
[[Page 65150]]
required to complete the technical software modifications necessary to
model master netting agreements. The interim and final haircuts for
derivative contract counterparties are as shown in the Table 2 below:
Table 2--Stress Test Haircuts for Derivative Contract Counterparties
------------------------------------------------------------------------
Haircuts for Haircuts for
Derivative Derivative
Counterparties Counterparties Number of
Ratings Classification prior to upon Phase-in
Implementation Implementation Months
of Netting of Netting
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Cash 0% 0% N/A
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AAA 0.3% 0.5% 120
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AA 0.75% 1.25% 120
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A 1.2% 2.0% 120
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BBB 2.4% 4.0% 120
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Below BBB and Unrated 100% 100%1
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Unrated Seller/servicers. The Rule treats unrated seller/servicers
as BBB-rated counterparties. OFHEO recognizes that certain unrated
seller-servicers to whom underwriting and servicing authority has been
delegated enter into loss-sharing agreements with the Enterprises and
collateralize these loss-sharing obligations with fully funded reserve
accounts pledged to the Enterprise. OFHEO is proposing to amend the
Rule to permit a higher rating than BBB for these seller-servicers if
the fully funded reserve account is equal to or greater than an amount
determined by OFHEO to be adequate to support the risk borne by the
seller-servicer under the loss sharing agreement. For example, if the
loss-sharing obligation of a seller-servicer participating in Fannie
Mae's Delegated Underwriting and Servicing (DUS) Program is
collateralized by a fully funded reserve account that is equal to or
greater than one percent of the seller-servicer's aggregate unpaid
principal balance covered by the loss-sharing agreement at the start of
the stress test, the rating of the issuer of the instrument backing the
reserve account may be used, in lieu of BBB, as the rating of the
unrated seller-servicer, except that in no event will the rating exceed
AA. Determinations of the required reserve amount and the rating
permitted would be made on a program-by-program and Enterprise-by-
Enterprise basis.
B. Proposed Changes to Multifamily Model
OFHEO is proposing a number of changes to the multifamily default
model, multifamily loss severity parameters, and multifamily prepayment
speeds specified in the Rule. Proposed changes to the default model
include (1) a respecification of explanatory variables which has the
effects of reducing the model's sensitivity to debt-service coverage
ratios (DCRs) falling below one and reducing predicted cumulative
default rates on adjustable rate mortgages (ARMs) in the up-rate stress
test, and (2) an increase to the initial vacancy rate used to update
DCR during the stress test making this rate consistent with the
benchmark region's vacancy rate from the month prior to the start of
the benchmark period.\13\ OFHEO is also proposing changes for the
multifamily loss severity parameters that reflect the costs, timing,
and recoveries associated with a larger and more broad-based set of
Enterprise foreclosures. The Rule reflects a decision not to model the
complexities of prepayment premiums that may or may not be received by
the Enterprises during stressful periods without further study. The
proposed multifamily prepayment speeds are more consistent with that
decision than existing pre-payment speeds. Each proposed change is
discussed in turn.
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\13\ The terms ``benchmark region and period'' refer to the
regional credit loss experience identified by OFHEO in compliance
with the ``Credit Loss'' parameters outlined in Title XIII of the
Housing and Community Development Act of 1992, Pub. L. No. 102-550,
known as the Federal Housing Enterprises Financial Safety and
Soundness Act of 1992 (1992 Act), as described in additional detail
in NPR2.
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Underwater Debt Coverage Ratio flag (UWDCRF). In the Rule, the
multifamily default model included an Underwater Debt Coverage Ratio
Flag (UWDCRF), intended to cover the additional default risk posed when
the projected debt service coverage ratio-net operating income (NOI)
divided by mortgage payment-falls below one during the stress test. A
debt coverage ratio less than one means that the NOI is insufficient to
cover the required mortgage payment, an occurrence that suggests a high
probability of default. The stress test projects the DCR in each month
of the stress period from the prior month's value by updating NOI,
using rent growth rates and rental vacancy rates that reflect the
economic conditions of the benchmark region and period, and adjusting
mortgage payments monthly according to the note terms and the stress
test interest rate scenario. When this method is used to project DCR,
the types of loans for which the projected DCR falls below one tend to
be fixed rate mortgages (FRMs) that started the stress test with a low
DCR and, in the up-rate scenario, most ARM loans, resulting in
comparatively high cumulative default rates for these loans in the
stress test.
OFHEO has found that the UWDCRF adds value to the multifamily
default model by capturing the additional risk of default when NOI is
insufficient to cover mortgage payments, but is concerned that the
sensitivity of predicted monthly defaults to projected DCR falling
below one may be too great, for two reasons. First, the UWDCRF is an
indicator that is only turned on when DCR is projected to be below one,
and is turned off otherwise. There are no finer gradations for this
explanatory variable such as those that might be captured if the
projected DCR accounted for individual property dispersion around the
mean.\14\ In the application of
[[Page 65151]]
the stress test, many multifamily loan groups will have DCRs projected
to fall below one--some only slightly below one, while others fall well
below one. The additional risk of default may be overstated for those
loan groups with DCRs projected to fall only slightly below one by the
abrupt transition of the UWDCRF variable. Second, even when a
multifamily property's DCR does fall below one, only a fraction of
borrowers default, indicating that those who do not default may carry
their properties with funds from other sources for a period of time
while they try to remedy the negative cash flow position.
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\14\ In the Rule's single-family default and prepayment models,
the level of borrower equity in the property (property value less
mortgage debt) is analogous to multifamily DCR in that both measures
capture economic stress. The circumstance of a single-family
mortgage borrower having negative equity is similar to that of a
multifamily loan having a DCR below one because both are associated
with increased likelihood of default. However, in the single-family
model, negative equity is captured as a probability and enters the
model as categorical variable having eight possible values. These
eight gradations for the probability of negative equity improve the
single-family model by avoiding abrupt predicted transitions from
positive to negative equity. OFHEO is able to calculate the
probability of negative equity for single-family loans because
projected property value changes are based on OFHEO's House Price
Index and its associated dispersion parameters. No similar measures
of dispersion are currently available to project multifamily DCR or
the probability of DCR falling below one.
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For these reasons, OFHEO decided to re-estimate the multifamily
default model with a revised definition of the UWDCRF that turns the
flag on only when the DCR is projected to be well below one. As a
result of that re-estimation, OFHEO proposes to redefine the UWDCRF to
be equal to one (that is, to turn the flag on) when projected DCR is
less than 0.98 (that is, when NOI is more than two percentage points
below the mortgage payment), rather than setting the flag equal to one
immediately when the projected DCR falls below one. The re-estimated
multifamily default model has a slightly lower coefficient on UWDCR,
and the coefficients for the other explanatory variables do not change
materially. Simulations using the revised UWDCRF definition result in
lower predicted default rates for ARMs in the up-rate scenario and for
FRMs with low initial DCR in both scenarios, making the model less
sensitive to the UWDCRF than the existing model. The revised definition
does not substantially affect the predicted default rates for most FRMs
or for ARMs in the down-rate scenario. OFHEO believes the respecified
model more accurately captures the added risks associated with loans
that have negative cash flow in the stress test.
ARM Flags. OFHEO is concerned that predicted cumulative default
rates for ARM loans are excessive in the up-rate scenario. For example,
a typical ARM purchased by an Enterprise could have a cumulative
default rate of 95 percent in the up-rate scenario. These excessive
default rates for ARMs in the up-rate stress test arise from two
principal sources. First, the up-rate stress test projects declining
DCRs for ARMs, and two explanatory variables in the default model
translate declining DCRs into higher default rates: the DCR variable,
itself, and the UWDCRF, where applicable. The second source is from the
application of an ARM product-type flag--New Book ARM Flag (NAF)--which
further raises the predicted ARM default rates. OFHEO included the ARM
product flag in the Rule because it observed in the historical data
from the Enterprises that ARM defaults appear to be higher than those
of otherwise comparable FRMs even after controlling for DCR changes due
to interest rate changes.
The stress test projects DCR in each month of the stress period
from the prior month's value using rent growth rates and vacancy rates
that reflect the economic conditions of the benchmark region and period
along with monthly mortgage payment adjustments according to the note
terms and the stress test interest rate scenarios. In the up-rate
scenario, the mortgage payment adjustments on ARMs cause the projected
DCR to fall much more than that of an otherwise comparable FRM. This
more rapid decline in DCR causes predicted defaults on ARMs to be
higher than those of otherwise comparable FRMs, as one would expect,
because mortgage payments on an ARM may grow to exceed net operating
income from the property. In addition, the NAF further raises new book
ARM defaults relative to comparable new book FRMs to capture
performance differences not related to projected changes in DCR.\15\
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\15\ The Rule includes a New Book ARM flag (NAF) and a New Book
Balloon flag (NBLF) as product-type offsets to the New Book flag
(NBF), which is a categorical (or dummy) variable that distinguishes
between ``Old Book'' loans that were made when the Enterprises first
entered into the multifamily business (before 1988 for Fannie Mae
and before 1993 for Freddie Mac) and ``New Book'' loans made under
their more recent restructured programs. OFHEO's research indicates
that New Book loans have shown lower defaults than Old Book loans in
general, although the amount of improvement varies significantly
among product types. Specifically, New Book fixed-rate balloon loans
outperformed Old Book fixed-rate balloon loans to a lesser degree
than their fixed-rate fully amortizing counterparts. ARM loan
performance differentials were even smaller. These differences are
reflected in the Rule in the NBLF and NAF offsets to the NBF.
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The theoretical justification for the inclusion of an ARM flag to
account for performance differences not related to ARM payment changes
is that ARM borrowers may possess higher credit risk qualities than
their fixed-rate counterparts. Arguing against the inclusion of an ARM
flag is the improvement in the Enterprises' multifamily ARM
underwriting in recent years, which means that, over time, differences
in risk between loan types due to differences in borrower
characteristics will disappear. That is, the choice of ARM versus FRM
in the multifamily mortgage market may be becoming a strategic business
decision related to professional financial management considerations
and may, as a result, have a declining relationship to borrower credit
quality.
OFHEO decided that the excessive predicted default rates for ARM
loans in the up-rate stress test warranted investigation of the default
model's specification of ARM product type flags. OFHEO sought to
determine if a respecification of the model could maintain a reasonable
relationship to the historical data while producing more reasonable
results in the stress test. First, the estimation was performed without
either of the two product type flags, the NAF and the New Book Balloon
Flag (NBLF). If the only additional risk associated with ARMs relative
to FRMs resulted from the impact of rate changes on mortgage payments
and DCR, then this specification for the default model might be
appropriate. OFHEO found, however, that this model specification caused
another explanatory variable, the Ratio Update Flag (RUF) to be no
longer statistically significant. Next, OFHEO re-estimated the model
without the Ratio Update Flag. The result of the second re-estimation
produced, as expected, an averaging effect between New Book ARM and FRM
default rates--that is, the size of the coefficient for New Book loans
decreased (the coefficient remained negative but had a smaller absolute
value), reflecting the fact that the NBF was now averaging the product
type differences that are currently separated out by the product type
flags in the Rule. This specification also reduced the sensitivity of
defaults to the distinction between New Book and Old Book loans,
holding other factors constant, because it no longer distinguished
between loans for which loan-to-value ratio (LTV) and DCR ratios are
updated and those for which they are not.\16\
---------------------------------------------------------------------------
\16\ This effect is captured in the Rule by the Ratio Update
Flag (RUF). Specifically, the RUF identifies a subset of New Book
loans--those for which the loan-to-value ratio (LTV) and debt-
service coverage ratio (DCR) have been calculated or delegated to
have been calculated by the Enterprises at loan origination or for
which the LTV and DCR have been recalculated or delegated to have
been recalculated by the Enterprises at Enterprise acquisition
according to current underwriting standards. New Book loans for
which origination and/or acquisition LTV and DCR are unknown cannot
be considered to be ratio-updated.
---------------------------------------------------------------------------
[[Page 65152]]
OFHEO rejected the above model re-specification, which eliminates
the NAF, the NBLF, and the RUF, because it ignored two important
factors that OFHEO has observed in Enterprise historical data. First,
OFHEO considered the evidence of higher Enterprise ARM default rates,
compared with FRM default rates during historical periods when interest
rates were flat to declining. Since flat-to-declining interest rates
lead to stable or lower ARM payments and therefore stable or higher
DCRs, all else equal, OFHEO suspected that factors unrelated to
interest-rate-related ARM payment changes (such as borrower credit
quality) may still be underlying the higher observed ARM default rates.
Second, OFHEO found substantial differences in observed default rates
for ratio-updated versus not-ratio-updated loans in Enterprise
historical data. Ratio-updated loans appear to perform better than
those that are not, holding other factors constant.
Therefore, OFHEO proposes to re-specify its multifamily default
model as follows. The proposed model has the same explanatory variables
as the model in the Rule, except that NAF, NBLF, and RUF are removed,
and a respecified flag is introduced that captures both the distinction
between ARMs and FRMs and the distinction between ratio-updated and
not-ratio-updated loans. Specifically, the new variable OFHEO is
proposing in its respecified default model is a Not-Ratio-updated ARM
Flag (NRAF) which takes a value of one (that is, it is turned on) if a
loan is both an ARM and not ratio-updated, and zero otherwise. Because
nearly all of the ARM loans in Enterprise historical data are not
ratio-updated, but nearly all of the FRMs are ratio-updated, OFHEO
determined that it is statistically difficult to fully separate these
effects as measures of historical performance. The proposed model with
the NRAF variable would apply this new variable coefficient during the
stress test simulation only to ARM loans that are not ratio-updated,
capturing the historical performance differences of these ARMs after
controlling for payment changes. ARM loans that have undergone the
ratio-update process would not be subject to higher default risk
imposed by the NRAF, thereby reducing the differential between ARM and
FRM defaults in the up-rate scenario for those loans.
OFHEO believes that a similar distinction between ratio-updated
FRMs and not-ratio-updated FRMs should exist even though there are too
few not-ratio-updated FRMs in the Enterprises' historical data to
confirm the hypothesis. As a result, OFHEO proposes to multiply monthly
conditional default rates for not-ratio-updated FRMs by a factor of 1.2
times the rates for otherwise comparable ratio-updated FRMs to reflect
the marginally higher risk expected with those loans.
OFHEO believes that, given the Enterprise data, the proposal
handles a very complicated issue fairly and with statistical soundness
and good judgment. If, in the future, Enterprise data show no
differences between ARM and FRM risk other than the adverse effect of
rising interest rates on ARM payments and ARM DCR, OFHEO may revisit
this issue.
Initial Vacancy Rate. Estimated rent growth for the first month of
the stress test is based on the relative change in a rent index from
immediately prior to the stress test to month one of the stress
test.\17\ However, the estimated vacancy rate change in the first month
of the stress test does not look back to the value of the vacancy rate
immediately prior to the stress test, but rather compares the vacancy
rate in month one of the stress test with a long-term national
historical average vacancy rate. To be consistent, the change in
vacancy rates between the period immediately prior to the stress test
and month one of the stress test should be based on the change in the
benchmark region vacancy rate from the month prior to the benchmark
period to the first month of the benchmark period. OFHEO views this
change as a technical correction.
---------------------------------------------------------------------------
\17\ Specifically, the twelfth root of month over same month
previous year rent indices minus one.
---------------------------------------------------------------------------
Specifically, the vacancy rate change in the Rule in the initial
month of the stress test is from the Census Bureau's long-term national
historical average of 6.23 percent to the West South Central (WSC)
Census division's estimated January, 1984, rate of 13.6 percent, with
changes thereafter based upon changes in rates through 1993 in that
region.\18\ This specification has the effect of imposing a greater
percentage increase in vacancies than appears to have occurred during
the benchmark loss experience.
---------------------------------------------------------------------------
\18\ Reporting of vacancy rate data for Metropolitan Statistical
Area located in the WSC Census division began in 1986. As a result,
1984 and 1985 rates were estimated based on national rates using the
ratio of WSC Census division rates to U.S. rental vacancy rates in
1986, a factor of 2.3. For 1983, a lower factor of 1.8 is assumed
because it predates the WSC Census division's recession.
---------------------------------------------------------------------------
The proposed change is to set the initial vacancy rate at ten
percent, which is the estimated WSC Census division vacancy rate in
1983. Thus, the vacancy rate change in the initial month of the stress
test would be from ten percent to 13.6 percent.
Loss Severity. Loss severity parameters in the Rule were based upon
the experience of 705 Freddie Mac multifamily REO \19\ properties from
the 1980s. OFHEO has now analyzed data reflecting the costs, timing,
and recovery rates associated with additional REO that has been made
available from both Enterprises. Based upon that analysis, OFHEO is
proposing to modify the multifamily severity parameters to take into
consideration the performance of Fannie Mae REO in the 1980s and both
Enterprises' more recent multifamily REO. The multifamily loss severity
calculations that use the severity parameters in the Rule would not
change. Specifically, OFHEO proposes reducing net REO holding costs to
seven percent from 13.33 percent and increasing REO sales proceeds from
58.88 percent to 63 percent of the unpaid principal balance as of the
default date. Additionally, OFHEO proposes reducing the time from
default to foreclosure completion from 18 to 9 months while increasing
the time from REO acquisition to REO disposition from 13 to 15 months.
Changing these severity parameters yields a 44 percent ``baseline''
severity rate, as compared to the 55 percent ``baseline'' produced by
the model in the Rule. ``Baseline'' severity is a simple way to compare
one set of severity parameters with another.\20\
---------------------------------------------------------------------------
\19\ REO is real estate owned as a result of loan default.
\20\ The ``baseline'' consists of a simple adding up of the cost
components of the rate, without considering discounting, credit
enhancements, or passthrough interest on sold loans.
---------------------------------------------------------------------------
Prepayment Penalties. In the Rule, no credit is given for cash
flows from prepayment penalties and yield maintenance provisions.
Nevertheless, the Rule provides that two percent of loans that are
subject to such penalties or provisions prepay each year of the stress
test in the down-rate scenario. In the preamble to the Rule, OFHEO
explained that the data indicated that a small percentage of loans did
prepay while subject to yield maintenance provisions and that OFHEO had
no data indicating to what extent prepayment penalties were actually
paid by borrowers, as opposed to waived by the Enterprises or added to
the balances of refinanced loans. Because it is likely that some
prepayment penalties are paid or other compensating consideration is
[[Page 65153]]
received by the Enterprises, OFHEO decided to include some prepayments
on these loans in the down-rate scenario, but at a lower rate than
indicated by the data in order to take prepayment penalties into
account.
OFHEO is proposing to modify the Rule to provide for no prepayments
in the down-rate scenario inside prepayment penalty or yield
maintenance periods. This approach is more consistent with OFHEO's
preference to model contractual instruments according to their terms,
but recognizes that modeling these penalties according to their terms
would be immensely complicated, because those terms vary greatly from
loan to loan. The proposed approach is a reasonable simplification
because prepayment penalty provisions are actually liquidated damages
clauses, which are intended to give the lender the benefit of full
performance on the loan.
C. Proposed Changes to Yields on Enterprise Debt
The Rule does not impose a premium upon an Enterprise's cost of
funds to reflect the reaction of the debt markets to the financial
stress imposed upon the Enterprise. However, the preamble to the Rule
suggested that a premium might be appropriate and that this would
likely be an area of future change. Upon further study, OFHEO has found
that it is appropriate for the stress test to recognize an increased
cost of debt of ten basis points for an Enterprise in the stress test
vis-a-vis other borrowers in the debt markets.
OFHEO proposed in NPR2 to impose a 50-basis-point premium on new
Enterprise debt for the last nine years of the stress period. The
analysis that OFHEO performed for NPR2 indicated that debt spreads to
Treasury rates have widened in times of financial stress for
Government-sponsored enterprises (GSEs). NPR2 did not propose
adjustments to reflect unusual stress for any other interest rate
series in the stress test.
In the final rule, OFHEO took note of the comments received in
response to NPR2, some of which questioned the appropriateness of a
premium on new Enterprise debt and the size of that premium. OFHEO
conceded that data upon which to base such a premium may be too sparse
to determine definitively whether other spreads to Treasuries would
widen as much as the Enterprises' spreads or to estimate how much the
Enterprises' spreads would widen. The preamble to the final rule also
noted that some commenters felt that no premium on new debt should be
charged because many of the Enterprises' hedging instruments are based
upon rates other than Treasuries (e.g., LIBOR, COFI). The spreads
between these rates and Treasuries could be expected to widen during
stressful conditions, thus mitigating the Enterprises' risk. In light
of these comments, OFHEO postponed imposition of any new debt premium
pending later refinements of the Rule. Nevertheless, OFHEO indicated
that the implicit assumption in the stress test that the spreads of an
Enterprise's debt yields to other interest rates would be unaffected by
the deteriorating condition of the Enterprise ignored an area of
significant risk.
The risk of wider spreads in a stressful period is important if
asset lives, which are unusually long in the up-rate scenario, exceed
terms-to-maturity of outstanding debt. In support of this proposal,
OFHEO notes that some funding strategies employed by the Enterprises
depend significantly on their ability to borrow in the future at
relatively favorable interest rates. For example, the Enterprises often
fund a portion of their mortgage asset portfolio with short-term debt
accompanied by interest rate swaps, in which they pay a fixed rate and
receive a floating rate. If the floating rate they pay on their own
short-term debt is close to the floating rate they receive on the swap,
the net effect is roughly the same as if they had issued long-term
fixed-rate debt at the rate they pay on the swap. If, however, their
cost of short-term funds rises significantly, relative to the index on
which the swap's floating rate is based, their cost will be higher than
if they had issued long-term fixed-rate debt. Use of fixed-pay
swaptions to hedge against the effect of rising interest rates on
expected asset lives creates a similar risk. Although the spreads to
Treasury rates of other interests rates may also widen in a stressful
economic environment, the stress test is designed to be especially
stressful to the Enterprises. The stress test involves factors, such as
a decline in housing prices, that might not affect the debt costs in
other sectors of the economy as much. OFHEO has chosen to propose a
ten-basis-point spread for the final nine years of the stress period,
in part to reflect these risks.
A ten-basis-point borrowing premium incorporates these risks in a
modest way. Firms in very stressful circumstances frequently face
premiums of several hundred basis points, if they are able to borrow at
all. GSEs, though, have always been able to borrow, even when they are
in very poor financial condition, because of their perceived special
status. It is reasonable, therefore, to use a much smaller premium than
might be appropriate for a non-GSE in a similar stress test. OFHEO also
considers it appropriate to consider that the stresses affecting the
Enterprises in the stress test would also be affecting other borrowers
in the market place. To assume that they do not, as was the case in
NPR2, which proposed a 50-basis-point premium, is inconsistent with the
stress implied in the haircuts that the stress test applies to all
counterparties of the Enterprises. An ideal stress test might model
different spreads for different interest rate series, a complex
approach that OFHEO could not implement in the foreseeable future. The
ten-basis-point premium, therefore, can be viewed as a simplifying
assumption, which gives some effect to the possibility that stress
period market conditions could impact an Enterprise more adversely than
the rest of the market.
D. Proposed Changes to New Debt Mix
The Rule provides for the funding of all cash deficits by the
issuance of new long-or short-term debt, whichever is in shorter
supply, until a 50/50 balance of short-to long-term debt is reached in
each Enterprise's portfolio. Thereafter, long- and short-term debt are
issued in whatever ratio best contributes to maintaining that balance.
This approach was chosen because OFHEO did not wish to include an
assumption about any particular behavioral preference by the
Enterprises during the stress period.
On further consideration, however, OFHEO proposes to change the
target balance embodied in this approach. A 50/50 balance is generally
unsuitable for funding a portfolio of largely fixed-rate mortgage
assets, and it could often result in a substantial change in an
Enterprise's funding structure during the stress period. OFHEO proposes
to replace the 50/50 target with the actual ratio of Enterprise debt
obligations (as adjusted by interest rate swaps) at the start of the
stress period. Typically, the Enterprises have a long-term debt to
total debt ratio (swap adjusted) of 70 percent to 90 percent. Use of
such ratios in the stress test will result in a more realistic debt
structure.
E. Miscellaneous Technical Changes
Operating Expenses. In the Rule, one third of an Enterprise's
operating expenses at the start of the stress test remain fixed
throughout the stress period, while the remainder decline in proportion
to the decline in the mortgage portfolio. The total of the fixed and
variable components is then reduced by one-third to recognize that a
[[Page 65154]]
cessation of new business would have a significant impact upon
operating expenses. The variable portion of the operating expenses for
a given month is determined by calculating the Enterprise's mortgage
portfolio at the end of each month of the stress period as a percentage
of the portfolio at the start of the stress test. Starting-position
fixed-asset balances are held constant over the ten-year stress period,
while related depreciation is included in the base on which operating
expenses are calculated for each month of the stress period. The
implication of this treatment is that fixed assets are being regularly
replaced throughout the period, which appears inconsistent with the
decline in financial assets as mortgages amortize and prepay.
To address this inconsistency, OFHEO is proposing to modify the
stress test treatment of operating expenses by converting 75 percent of
starting-position fixed-asset balances to cash over the ten-year stress
period. The proposal would retain 25 percent of the fixed assets on the
Enterprise books throughout the stress period to reflect the
acquisition of some new fixed assets, such as computer equipment, which
is likely even in a ``wind-down'' scenario. The effect of this change
is to reduce the Enterprises' need for debt to carry nonearning fixed
assets.
Float Income. The Rule provides for the modeling of float income
associated with passthrough payments on securities issued by the
Enterprises. Float income can be positive or negative depending on
whether the Enterprise holds the funds for a period of time before
remitting them to security holders or remits funds to security holders
before they are actually received. When an Enterprise owns its own
passthrough securities, the timing of payment to itself is not
relevant. However, the Rule includes these securities in the
calculation of float income, resulting in an overstatement of float
income. OFHEO proposes to correct this overstatement by reducing the
float income on passthrough securities issued by the reporting
Enterprise by the percentage of the Enterprise's ownership interest.
However, when an Enterprise receives prepayments and holds the funds
for a number of days during which investors accrue interest at the
coupon rate of the security, the difference between the yield the
Enterprise can earn on invested funds at that time of the stress period
and the coupon rate will continue to be reflected for the relevant
number of days.
Currency Swaps. As a simplifying assumption in the Rule, OFHEO
applied no haircut to foreign currency swaps, but stated its intention
to continue to explore appropriate methodologies for applying an
appropriate haircut. In furtherance of its commitment to continue to
refine the stress test, OFHEO now proposes to eliminate the simplifying
assumption and apply haircuts to foreign currency swap counterparties.
Because the stress test does not project foreign currency values, the
haircut is applied by adjusting the pay (dollar-denominated) side of
the swap upward by the amount of the haircut percentage rather than
haircutting the foreign-currency receive side of the swap.
American Call Option. As a simplifying assumption in the Rule, an
American call option, which allows the issuer to exercise the option at
any time, is treated as a Bermudan call option, which allows the issuer
to exercise the call only on a coupon date. However, in the preamble to
the Rule, OFHEO signaled its intention to consider how American call
options might be modeled more precisely. OFHEO is now proposing to
modify the stress test to evaluate American calls on the first option
date in the exercise schedule and subsequent monthly anniversaries of
the instrument's first coupon date.
House Price Growth Factor Clarification. The Rule requires the use
of OFHEO's most recent House Price Index as of the reporting date to
determine the house price growth factor used to calculate current loan-
to-value ratios. The proposal expands the instructions in Section 3.6
to clarify, consistent with Section 3.7, that when a loan was
originated since the publication of that report, a cumulative house
price growth factor of one is used.
Technical Correction. The proposal adds a Prepayment Penalty Flag
as an additional classification variable for multifamily loan groups,
to distinguish loans with active prepayment penalties or yield
maintenance provisions from those without in the calculation of
prepayment penalty duration for loan groups.
Regulatory Impact
Executive Order 12866, Regulatory Planning and Review
The proposed amendment would amend a rule designated as a major
rule by the Office of Management and Budget (OMB). The proposed
amendment is a refinement of that rule that would tie the capital more
closely to risk. Although the impact of that refinement is not
economically significant, OMB has reviewed the proposed amendment to
determine whether the proposed changes may raise novel policy issues.
OFHEO is not required to provide the type of regulatory impact analysis
that is required for an economically significant rule. Nevertheless, in
accordance with OMB's guidance that all regulatory actions should be
consistent with the principles of E.O. 12866, OFHEO has determined,
after review by agency economists, financial analysts, and attorneys,
that the benefits of the proposed changes to the Rule substantially
outweigh any economic costs.
It is impossible to estimate precisely the particular benefits and
costs associated with the risk-based capital requirement. While OFHEO
believes this group of enhancements and refinements to the stress test
will not generally increase or decrease the amount of required capital
for an Enterprise to any substantial degree, the effect in any
particular quarter depends upon how well that Enterprise is hedged
against the risks and conditions specified in the stress test. OFHEO
cannot know whether or not hedges in place at an Enterprise at the
beginning of any quarter would have been in place in the absence of
specific provisions of the risk-based capital rule or were put in place
because of the test. Speculating as to what the Enterprises would do in
the absence of specific provisions in future quarters is even more
difficult. Therefore, a detailed economic cost/benefit analysis is not
practical.
Rather than trying to assess the costs and benefits of every change
to the stress test, OFHEO looks to whether or not the changes it is
proposing make the Rule better reflect the risks faced by the
Enterprises. Improving the Rule in this manner should reduce the
potential for Enterprise insolvency by protecting better against
interest rate, credit, and management and operations risk. By helping
to ensure the safety and soundness of the Enterprises, the regulation
allows them to continue to carry out their public purposes, which
include providing stability in the secondary market for residential
mortgages and providing access to mortgage credit in central cities,
rural areas, and underserved areas.\21\ In addition, the regulation
helps ensure that the Enterprises will continue to provide benefits to
the primary mortgage market, such as standardizing business
practices.\22\
---------------------------------------------------------------------------
\21\ 1992 Act, section 1302(2) (12 U.S.C. 4501(2)).
\22\ ``Managing Risk in Housing Finance Markets: Perspective
from the Experience of the United States of America and Mexico,''
Mortgage Bankers Association of America (June 11, 1998).
---------------------------------------------------------------------------
[[Page 65155]]
Adopting the proposed amendment will result in a capital
requirement that corresponds more closely to capital levels that the
marketplace would demand in the absence of the benefits afforded by the
Government sponsorship of the Enterprises, leading to gains in overall
economic efficiency. By improving the Rule's ability to reflect actual
risks at the Enterprises, the amendment also may enhance investor
confidence in the ability of the stress test to forewarn investors and
regulators of financial weaknesses. This result would be consistent
with a study by Standard & Poor's (S&P) that provided risk-to-the-
government credit ratings for the Enterprises.\23\ Although S&P had
rated Fannie Mae A- and Freddie Mac A+ in 1991, the 1997 report
upgraded the ratings of both Enterprises to AA-. S&P cited increased
governmental oversight by OFHEO as an important factor in these higher
ratings. It further noted that ``OFHEO's regulatory oversight [of
Freddie Mac] also gives comfort that appropriate interest rate risk
mitigation steps would be taken as needed.''\24\
---------------------------------------------------------------------------
\23\ Final Report of Standard & Poor's to OFHEO, Contract No.
HE09602C (February 3, 1997).
\24\ Contract No. HE09602C, at 10.
---------------------------------------------------------------------------
OFHEO can identify no significant costs associated with
implementing the proposed amendments. No new reports are required, and
net effects on required capital likely will be very small. In sum, the
benefits to the public, including the Enterprises and other private-
sector concerns, of the proposed changes far outweigh the already
expended costs of implementing those changes.
Paperwork Reduction Act
This proposed regulation does not contain any information
collection requirements that require the approval of the Office of
Management and Budget under the Paperwork Reduction Act (44 U.S.C. 3501
et seq.).
Regulatory Flexibility Act
The Regulatory Flexibility Act (5 U.S.C. 601 et seq.) requires that
a regulation that has a significant economic impact on a substantial
number of small entities, small businesses, or small organizations must
include an initial regulatory flexibility analysis describing the
regulation's impact on small entities. Such an analysis need not be
undertaken if the agency has certified that the regulation will not
have a significant economic impact on a substantial number of small
entities. 5 U.S.C. 605(b). OFHEO has considered the impact of the
proposed regulation under the Regulatory Flexibility Act. The General
Counsel of OFHEO certifies that the proposed regulation, if adopted, is
not likely to have a significant economic impact on a substantial
number of small business entities because the regulation is applicable
only to the Enterprises, which are not small entities for purposes of
the Regulatory Flexibility Act.
List of Subjects in 12 CFR Part 1750
Capital classification, Mortgages, Risk-based capital.
Accordingly, for the reasons stated in the preamble, OFHEO proposes
to amend 12 CFR part 1750 as follows:
PART 1750--RISK-BASED 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. Revise Table 3-1 in paragraph 3.1.1;
b. Revise Table 3-4 in paragraph 3.1.2.1;
c. Revise paragraph 3.3.1 [b];
d. Revise paragraph 3.3.3 [a] 3.c.;
e. Add new paragraph 3.5.3 [a] 2.d.;
f. Revise paragraph 3.5.3 [a] 3. and Table 3-31;
g. In sentence six of paragraph 3.6.1 [e], remove the comma after
the words ``Credit Losses'', add the word ``and'' in its place, and
remove the words ``and the Float Income'' after the words ``Guarantee
Fee'';
h. Revise paragraph 3.6.3.4.3.1 [a] 2.a.;
i. Revise paragraph 3.6.3.5.1 [b];
j. In paragraph 3.6.3.5.2, revise Table 3-38;
k. Revise paragraph 3.6.3.5.3.1 [a] 2.;
l. In paragraph 3.6.3.5.3.1 [a] 4, remove the first equation:
``UWDCRFm = 1 if DCRm 1 in month m'' and add the
equation ``UWDCRFm = 1 if DCRm 0.98 in month m''
in its place;
m. Revise paragraph 3.6.3.5.3.2 [a] 1. and Table 3-39;
n. Revise paragraph 3.6.3.5.3.2 [a] 2.b.;
o. Revise paragraph 3.6.3.5.3.2 [a] 3.;
p. Revise Table 3-44, in paragraph 3.6.3.6.3.2;
q. In section 3.6.3.6.4.3, revise the four paragraphs: [a] 1., [a]
3.b., [a] 4.b. and [a] 5.;
r. Revise paragraph 3.6.3.7.3 [a] 9.b.;
s. Revise paragraph 3.7.3.1 [g] 1.;
t. In paragraphs 3.7.3.2 [a] 5. and 3.7.3.3 [a] 3., add the words
``, as appropriate'' at the end of the sentence in each paragraph;
u. In paragraph 3.7.4 [a] remove reference to ``Table 3-55'' and
add ``Table 3-61'' in its place;
v. Redesignate Tables 3-65 through 3-70 as Tables 3-66 through 3-
71;
w. After paragraph 3.8.1 [e], add new paragraph 3.8.1 [f], new
footnote 5, and new Table 3-65;
x. In paragraphs 3.8.2 [a] and [b] remove references to ``Table 3-
65'' and add ``Table 3-66'' in their place;
y. Revise paragraph 3.8.3.1 [a] 3.a.;
z. In paragraph 3.8.3.4 remove reference to ``Table 3-66'' and add
``Table 3-67'' in its place;
aa. In paragraphs 3.8.3.6.1 [e] 1. and [e] 2. remove both
references to ``Table 3-67'' and add ``Table 3-68'' in their place;
bb. In redesignated Table 3-69 in paragraph 3.8.3.9, remove both
references to ``Table 3-65'' and add ``Table 3-66'' in their place;
cc. Revise paragraphs 3.8.3.10 [a], [b] and [c];
dd. In paragraph 3.9.2 remove reference to ``Table 3-69'' and add
``Table 3-70'' in its place;
ee. In paragraph 3.10.2 [a] remove reference to ``Table 3-70'' and
add ``Table 3-71'' in its place;
ff. Revise paragraphs 3.10.3.1 [b] 2. and [b] 3.;
gg. Revise paragraph 3.10.3.6.2 [a] 5.; and
hh. Revise the definition of Enterprise Cost of Funds in paragraph
4.0 Glossary.
The revisions and additions read as follows:
Appendix A to Subpart B of Part 1750--Risk-Based Capital Text
Methodology and Specifications
* * * * *
3.1.2.1 * * *
[[Page 65156]]
Table 3-1-Sources of Stress Test Input Data
------------------------------------------------------------------------
Data Source(s) R = RBC Report P
= Public Data F = Fixed Values
Section of this Table -----------------------------------
Appendix Intermediate
R P F Outputs
------------------------------------------------------------------------
3.1.3, Public 3-19, Stress Test .... .... F
Data Single Family
Quarterly House
Price Growth
Rates
------------------------------------------------------
3-20, Multifamily .... .... F
Monthly Rent
Growth and
Vacancy Rates
------------------------------------------------------------------------
3.2.2., Characteristics R .... .... 3.3.4, Interest
Commitments of securitized Rates Outputs
Inputs single family
loans originated
and delivered
within 6 months
prior to the
Start of the
Stress Test
------------------------------------------------------------------------
3.2.3., 3-25, Monthly .... .... F
Commitments Deliveries as a
Procedures Percentage of
Commitments
Outstanding
(MDP)
------------------------------------------------------------------------
3.3.2, Interest 3-18, Interest .... P
Rates Inputs Rate and Index
Inputs
------------------------------------------------------------------------
3.3.3, Interest 3-26, CMT Ratios .... .... F
Rates Procedures to the Ten-Year
CMT
------------------------------------------------------------------------
3.4.2., Property 3-28, Property .... .... .... 3.1.3, Public
Valuation Inputs Valuation Inputs Data
3.3.4, Interest
Rates Outputs
------------------------------------------------------------------------
3.5.3., 3-30, Rating .... P
Counterparty Agencies
Defaults Mappings to
Procedures OFHEO Ratings
Categories
------------------------------------------------------
3-31, Stress Test .... .... F
Maximum Haircut
by Ratings
Classification
------------------------------------------------------------------------
3.6.3.3.2, 3-32, Loan Group .... .... .... 3.3.4, Interest
Mortgage Inputs for Rates Outputs
Amortization Mortgage
Schedule Inputs Amortization
Calculation
------------------------------------------------------------------------
3.6.3.4.2, Single 3-34, Single R .... F 3.6.3.3.4,
Family Default Family Default Mortgage
and Prepayment and Prepayment Amortization
Inputs Inputs Schedule
Outputs
------------------------------------------------------------------------
3.6.3.4.3.2, 3-35, .... .... F
Prepayment and Coefficients for
Default Rates Single Family
and Performance Default and
Fractions Prepayment
Explanatory
Variables
------------------------------------------------------------------------
3.6.3.5.2, 3-38, Loan Group R .... F
Multifamily Inputs for
Default and Multifamily
Prepayment Default and
Inputs Prepayment
Calculations
------------------------------------------------------------------------
3.6.3.5.3.2, 3-39, Explanatory .... .... F 3.6.3.3.4,
Default and Variable Mortgage
Prepayment Rates Coefficients for Amortization
and Performance Multifamily Schedule
Fractions Default Outputs
------------------------------------------------------------------------
3.6.3.6.2.2, 3-42, Loan Group .... .... F 3.3.4, Interest
Single Family Inputs for Gross Rates Outputs
Gross Loss Loss Severity 3.6.3.3.4,
Severity Inputs Mortgage
Amortization
Schedule
Outputs
3.6.3.4.4,
Single Family
Default and
Prepayment
Outputs
------------------------------------------------------------------------
3.6.3.6.3.2, 3-44, Loan Group .... .... F 3.3.4, Interest
Multifamily Inputs for Rates Outputs
Gross Loss Multifamily 3.6.3.3.4,
Severity Inputs Gross Loss Mortgage
Severity Amortization
Schedule
Outputs
------------------------------------------------------------------------
3.6.3.6.4.2, 3-46, CE Inputs R .... .... 3.6.3.3.4,
Mortgage Credit for each Loan Mortgage
Enhancement Group Amortization
Inputs Schedule
Outputs
3.6.3.4.4,
Single Family
Default and
Prepayment
Outputs
3.6.3.5.4,
Multifamily
Default and
Prepayment
Outputs
3.6.3.6.2.4,
Single Family
Gross Loss
Severity
Outputs
3.6.3.6.3.4,
Multifamily
Gross Loss
Severity
Outputs
------------------------------------------------------
3-47, Inputs for R
each Distinct CE
Combination
(DCC)
------------------------------------------------------------------------
3.6.3.7.2, Stress 3-51, Inputs for R .... .... 3.3.4, Interest
Test Whole Loan Final Rates Outputs
Cash Flow Inputs Calculation of 3.6.3.3.4,
Stress Test Mortgage
Whole Loan Cash Amortization
Flows Schedule
Outputs
3.6.3.4.4,
Single Family
Default and
Prepayment
Outputs
3.6.3.5.4,
Multifamily
Default and
Prepayment
Outputs
3.6.3.6.5.2,
Single Family
and Multifamily
Net Loss
Severity
Outputs
------------------------------------------------------------------------
3.6.3.8.2, Whole 3-54, Inputs for R .... .... 3.6.3.7.4,
Loan Accounting Whole Loan Stress Test
Flows Inputs Accounting Flows Whole Loan Cash
Flow Outputs
------------------------------------------------------------------------
[[Page 65157]]
3.7.2., Mortgage- 3-56, RBC Report R
Related Inputs for
Securities Single Class MBS
Inputs Cash Flows
3-57, RBC Report R
Inputs for Multi-
Class and
Derivative MBS
Cash Flows
3-58, RBC Report R
Inputs for MRBs
and Derivative
MBS Cash Flows
3.8.2., 3-66, Input R
Nonmortgage Variables for
Instrument Nonmortgage
Inputs Instrument Cash
flows
3.9.2., 3-70, Alternative R
Alternative Modeling
Modeling Treatment Inputs
Treatments
Inputs
------------------------------------------------------------------------
3.10.2., 3-71, Operations, R .... .... 3.3.4, Interest
Operations, Taxes, and Rates Outputs
Taxes, and Accounting 3.6.3.7.4,
Accounting Inputs Stress Test
Inputs Whole Loan Cash
Flow Outputs
3.7.4., Mortgage-
Related
Securities
Outputs
3.8.4.,
Nonmortgage
Instrument
Outputs
------------------------------------------------------------------------
3.12.2., Risk- ................. R .... .... 3.3.4, Interest
Based Capital Rates Outputs
Requirement 3.9.4.,
Inputs Alternative
Modeling
Treatments
Outputs
3.10.4.,
Operations,
Taxes, and
Accounting
Outputs
------------------------------------------------------------------------
* * * * *
3.1.2.1 * * *
Table 3-4.--Additional Multifamily Loan Classification Variables
----------------------------------------------------------------------------------------------------------------
Variable Description Range
----------------------------------------------------------------------------------------------------------------
Multifamily Product Code Identifies the mortgage product Fixed Rate Fully Amortizing
types for multifamily loans Adjustable Rate Fully Amortizing
5 Year Fixed Rate Balloon
7 Year Fixed Rate Balloon
10 Year Fixed Rate Balloon
15 Year Fixed Rate Balloon
Balloon ARM
Other
----------------------------------------------------------------------------------------------------------------
New Book Flag ''New Book'' is applied to Fannie New Book
Mae loans acquired beginning in Old Book
1988 and Freddie Mac loans acquired
beginning in 1993, except for loans
that were refinanced to avoid a
default on a loan originated or
acquired earlier.
----------------------------------------------------------------------------------------------------------------
Ratio Update Flag Indicates if the LTV and DCR were Yes
updated at origination or at No
Enterprise acquisition
----------------------------------------------------------------------------------------------------------------
Interest Only Flag Indicates if the loan is currently Yes
paying interest only. Loans that No
started as I/Os and are currently
amortizing should be flagged as
`N'.
----------------------------------------------------------------------------------------------------------------
Current DCR Assigned classes for the Debt DCR 1.00
Service Coverage Ratio based on the 1.00 =DCR1.10
most recent annual operating 1.10 =DCR1.20
statement 1.20 =DCR1.30
1.30 =DCR1.40
1.40 =DCR1.50
1.50 =DCR1.60
1.60 =DCR1.70
1.70 =DCR1.80
1.80 =DCR1.90
1.90 =DCR2.00
2.00 =DCR2.50
2.50 =DCR4.00
DCR >= 4.00
----------------------------------------------------------------------------------------------------------------
Prepayment Penalty Flag Indicates if prepayment of the loan Yes
is subject to active prepayment No
penalties or yield maintenance
provisions
----------------------------------------------------------------------------------------------------------------
* * * * *
3.3.1 * * *
[b] The process for determining interest rates is as follows:
first, identify values for the necessary Interest Rates at time
zero; second, project the ten-year CMT for each month of the Stress
Period as specified in the 1992 Act; third, project the 1-month
Treasury yield, the 3-month, 6-month, 1-, 2-, 3-, 5-, 20-
[[Page 65158]]
and 30-year CMTs; fourth, project non-Treasury Interest Rates,
including the Federal Agency Cost of Funds Index; and fifth, project
the Enterprises Cost of Funds Index, which provides borrowing rates
for the Enterprises during the Stress Period, by increasing the
Agency Cost of Funds Index by 10 basis points for the last 108
months of the Stress Test.
* * * * *
3.3.3 * * *
[a] * * *
3. * * *
c. Enterprise Borrowing Rates. In the Stress Test, the Federal
Agency Cost of Funds Index is the same as the Enterprise Cost of
Funds Index during the Stress Period, except that the Stress Test
adds a 10 basis-point credit spread to the Federal Agency Cost of
Funds rates to project Enterprise Cost of Funds rates for the last
108 months of the Stress Period.
* * * * *
3.5.3 * * *
[a] * * *
2. * * *
d. The Stress Test will permit a higher rating to be used for an
unrated seller-servicer who participates in a delegated underwriting
and servicing program that requires a loss-sharing agreement when:
(1) The loss sharing agreement is collateralized by a fully funded
reserve account pledged to the Enterprise; and (2) the reserve
account is in an amount that is equal to or exceeds the amount that
OFHEO has determined to be adequate to support the seller-servicer's
loss-sharing obligation under the program. Determinations of the
reserve requirement and of the rating that will be permitted will be
made on a program-by-program and Enterprise-by-Enterprise basis by
the Director.
3. Determine Maximum Haircuts. The Stress Test specifies the Maximum
Haircut (i.e., the maximum reduction applied to cash flows during
the Stress Test to reflect the risk of loss due to counterparty
(including security) default) by rating category and counterparty
type as shown in Table 3-31.
a. The Maximum Haircut for a rating category is the product of
its default rate and its loss severity rate. For all counterparties
the default rates are 5 percent for AAA, 12.5 percent for AA, 20
percent for A, 40 percent for BBB and 100 percent for Below BBB and
Unrated. For non-derivative counterparties, the loss severity rate
is 70 percent; for derivative counterparties, it is 10 percent. For
all Below BBB and Unrated counterparties, the loss severity rate is
100 percent.
b. For periods prior to the implementation of netting, a
separate set of Maximum Haircuts (set forth in Table 3-31) will be
applied to derivative contract cash flows to approximate the impact
of the net exposures to derivative contract counterparties (see
section 3.8.3, Nonmortgage Instrument Procedures). After the
implementation of netting, exposures will be netted as described in
section 3.8.3 before the haircut is applied.
c. With the exception of haircuts for the Below BBB and Unrated
category, haircuts for all counterparty categories are phased-in
linearly over the 120 months of the Stress Period. The Maximum
Haircut is applied in month 120 of the Stress Period. Haircuts for
the Below BBB and Unrated category are applied fully starting in the
first month of the Stress Test.
Table 3-31.--Stress Test Maximum Haircut by Ratings Classification
----------------------------------------------------------------------------------------------------------------
Derivative Derivative
Contract Contract Non-Derivative
Counterparties Counterparties Contract Number of
Ratings Classification prior to after Counterparties Phase-in
Implementation Implementation or Instruments Months
of Netting of Netting
----------------------------------------------------------------------------------------------------------------
Cash 0% 0% 0% N/A
----------------------------------------------------------------------------------------------------------------
AAA 0.3% 0.5% 3.5% 120
----------------------------------------------------------------------------------------------------------------
AA 0.75% 1.25% 8.75% 120
----------------------------------------------------------------------------------------------------------------
A 1.2% 2% 14% 120
----------------------------------------------------------------------------------------------------------------
BBB 2.4% 4% 28% 120
----------------------------------------------------------------------------------------------------------------
Below BBB and Unrated 100% 100% 100% 1
----------------------------------------------------------------------------------------------------------------
* * * * *
3.6.3.4.3.1 * * *
[a] * * *
2. * * *
a. LTVq is evaluated for a quarter q as:
[GRAPHIC] [TIFF OMITTED] TP18DE01.003
The HPI at Origination is updated to the beginning of the Stress
Test using actual historical experience as measured by the OFHEO
HPI; and then updated within the Stress Test using House Price
Growth Factors from the Benchmark region and time period:
[GRAPHIC] [TIFF OMITTED] TP18DE01.004
Where:
UPBm=3q-3 = UPB for the month at the end of the quarter
prior to quarter q
CHPGFoLG= 1.0 if the loan was originated in the same
quarter as or after the most recently available HPI as of the
reporting date
* * * * *
3.6.3.5.1
[b] Explanatory Variables for Default Rates. Eight explanatory
variables are used as specified in the equations section
3.6.3.5.3.1, of this Appendix, to determine Default rates for
multifamily loans: Mortgage Age, Mortgage Age Squared, New Book
indicator, Not Ratio-updated ARM indicator, current Debt-Service
Coverage Ratio, Underwater Current Debt-Service Coverage indicator,
Loan-To-Value Ratio at origination/acquisition, and a Balloon
Maturity indicator. Regression coefficients (weights) are associated
with each variable. All of this information is used to compute
conditional annual Default rates throughout the Stress Test. The
annualized Default rates are converted to monthly conditional
Default rates and are used together with monthly conditional
Prepayment rates to calculate Stress Test Whole Loan Cash Flows.
(See section 3.6.3.7, Stress Test Whole Loan Cash Flows, of this
appendix).
* * * * *
3.6.3.5.2
[[Page 65159]]
Table 3-38--Loan Group Inputs for Multifamily Default and Prepayment Calculations
----------------------------------------------------------------------------------------------------------------
Variable Description Source
----------------------------------------------------------------------------------------------------------------
Mortgage Product Type RBC Report
----------------------------------------------------------------------------------------------------------------
A0 Age immediately prior to start of Stress RBC Report
Test, in months (weighted average for Loan
Group)
----------------------------------------------------------------------------------------------------------------
NBF New Book Flag RBC Report
----------------------------------------------------------------------------------------------------------------
RUF Ratio Update Flag RBC Report
----------------------------------------------------------------------------------------------------------------
LTVORIG Loan-to-Value ratio at loan Origination RBC Report
----------------------------------------------------------------------------------------------------------------
DCR0 Debt Service Coverage Ratio at the start of RBC Report
the Stress Test
----------------------------------------------------------------------------------------------------------------
PMT0 Amount of the mortgage Payment (principal and RBC Report
interest) prior to the start of the Stress
Test, or first Payment for new loans
(aggregate for Loan Group)
----------------------------------------------------------------------------------------------------------------
PPEM Prepayment Penalty End Month number in the RBC Report
Stress Test (weighted average for Loan
Group)
----------------------------------------------------------------------------------------------------------------
RM Remaining term to Maturity in months (i.e., RBC Report
number of contractual payments due between
the start of the Stress Test and the
contractual maturity date of the loan)
(weighted average for Loan Group)
----------------------------------------------------------------------------------------------------------------
RGRm Benchmark Rent Growth for months m = 1 120 of section 3.4.4, Property
the Stress Test Valuation Outputs
----------------------------------------------------------------------------------------------------------------
RVRm Benchmark Vacancy Rates for months m = 1 120 section 3.4.4, Property
of the Stress Test Valuation Outputs
----------------------------------------------------------------------------------------------------------------
PMTm Scheduled Payment for months m = 1 RM 3.6.3.3.4, Mortgage
Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
OE Operating expenses as a share of gross fixed decimal from
potential rents (0.472) Benchmark region and time
period
----------------------------------------------------------------------------------------------------------------
RVRo Initial rental vacancy rate 0.10
----------------------------------------------------------------------------------------------------------------
* * * * *
3.6.3.5.3.1 * * *
[a] * * *
2. Assign product and ratio update flags (NBF, NRAF). Note: these
values do not change over time for a given Loan Group.
a. New Book Flag (NBF):
NBF = 1 for Fannie Mae loans acquired after 1987 and Freddie Mac
loans acquired after 1992, except for loans that were refinanced to
avoid a Default on a loan originated or acquired earlier.
NBF = 0 otherwise.
b. Not Ratio-updated Arm Flag (NRAF):
NRAF = 1 if both ARMF = 1 and RUF = 0,
NRAF = 0 otherwise.
Where:
ARMF = 1 for ARMs (including Balloon ARMs)
ARMF = 0 otherwise, and
RUF = 1 if the LTV and DCR were calculated or delegated to have been
calculated at origination or recalculated or delegated to have been
recalculated at Enterprise acquisition according to current
Enterprise standards.
RUF = 0 otherwise
* * * * *
3.6.3.5.3.2 * * *
[a] * * *
1. Compute the logits for multifamily Default using inputs from
Table 3-38 and coefficients from Table 3-39. For indexing purposes,
the Default rate for a period m is the likelihood of missing the
mth payment; calculate its corresponding logit
(Xm) based on Loan Group characteristics as of
the period prior to m, i.e. prior to making the mth payment.
[GRAPHIC] [TIFF OMITTED] TP18DE01.005
Table 3-39--Explanatory Variable Coefficients for Multifamily Default
------------------------------------------------------------------------
Default Weight (v)
------------------------------------------------------------------------
AY 0.5256
------------------------------------------------------------------------
AY2 -0.0284
------------------------------------------------------------------------
NBF -1.219
------------------------------------------------------------------------
NRAF 0.4193
------------------------------------------------------------------------
DCR -2.368
------------------------------------------------------------------------
UWDCRF 1.220
------------------------------------------------------------------------
LTV 0.8165
------------------------------------------------------------------------
BMF 1.518
------------------------------------------------------------------------
Intercept (0) -4.553
------------------------------------------------------------------------
* * * * *
2. * * *
b. For the down-rate scenario, APRm = 0 percent
during the Prepayment penalty period (i.e., when m PPEM)
APRm = 25 percent after the Prepayment penalty period
(i.e., when m > PPEM)
* * * * *
3. Convert annual Prepayment and Default rates to monthly rates (MPR
and MDR) using the following formulas for simultaneous processes:
[GRAPHIC] [TIFF OMITTED] TP18DE01.006
If both ARMF = 0 and RUF = 0, then
[[Page 65160]]
[GRAPHIC] [TIFF OMITTED] TP18DE01.007
otherwise,
[GRAPHIC] [TIFF OMITTED] TP18DE01.008
* * * * *
3.6.3.6.3.2 * * *
Table 3-44--Loan Group Inputs for Multifamily Gross Loss Severity
----------------------------------------------------------------------------------------------------------------
Variable Description Value or Source
----------------------------------------------------------------------------------------------------------------
Government Flag RBC Report
----------------------------------------------------------------------------------------------------------------
DRm Discount Rate in month m (decimal per annum) 6-month Enterprise Cost of
Funds from Section 3.3,
Interest Rates
----------------------------------------------------------------------------------------------------------------
MQ Time during which delinquent loan interest is 4 for sold loans
passed-through to MBS holders 0 otherwise
----------------------------------------------------------------------------------------------------------------
PTRm Pass Through Rate applicable to payment due section 3.6.3.3.4, Mortgage
in month m (decimal per annum) Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
NYRm Net Yield Rate applicable to payment due in section 3.6.3.3.4, Mortgage
month m (decimal per annum) Amortization Schedule
Outputs
----------------------------------------------------------------------------------------------------------------
RHC Net REO holding costs as a decimal fraction 0.07
of Defaulted UPB
----------------------------------------------------------------------------------------------------------------
MF Time from Default to completion of 9 months
foreclosure (REO acquisition)
----------------------------------------------------------------------------------------------------------------
MR Months from REO acquisition to REO 15 months
disposition
----------------------------------------------------------------------------------------------------------------
RP REO proceeds as a decimal fraction of 0.63
Defaulted UPB
----------------------------------------------------------------------------------------------------------------
* * * * *
3.6.3.6.4.3 * * *
[a] * * *
1. Determine Mortgage Insurance Payment (MIm) for single
family loans in the DCC, or Loss Sharing Payment (LSAm)
for multifamily loans in the DCC, as a percentage of Defaulted UPB,
applying appropriate counterparty Haircuts from section 3.5, of this
Appendix:
[GRAPHIC] [TIFF OMITTED] TP18DE01.009
[GRAPHIC] [TIFF OMITTED] TP18DE01.010
Where:
m' = m, except for counterparties rated below BBB, where m' = 120
[GRAPHIC] [TIFF OMITTED] TP18DE01.011
* * * * *
3.* * *
b. Determine CE Payment in Dollars after application of
Haircuts:
[GRAPHIC] [TIFF OMITTED] TP18DE01.012
Where:
m' = m, except for counterparties rated below BBB, where m' = 120
* * * * *
4.* * *
b. Determine CE Payment in Dollars after application of
Haircuts:
[GRAPHIC] [TIFF OMITTED] TP18DE01.013
Where:
m' = m, except for counterparties rated below BBB, where m' = 120
* * * * *
5. Convert Aggregate Limit First and Second Priority Contract
receipts in Dollars for each DCC in month m to a percentage of DCC
Defaulted UPB:
[GRAPHIC] [TIFF OMITTED] TP18DE01.014
[[Page 65161]]
Where:
ELPIDCC,C = 0 if ELPFDCC,C = Y (Yes,
indicating that Contract C is an Enterprise Loss Position)
ELPIDCC,C = 1 otherwise
* * * * *
3.6.3.7.3. * * *
[a] * * *
9. * * *
b. Float Income (FI) received in month m
[GRAPHIC] [TIFF OMITTED] TP18DE01.015
Where:
Prepayment Interest Shortfall (PIS) in month m is:
[GRAPHIC] [TIFF OMITTED] TP18DE01.016
* * * * *
3.7.3.1 * * *
[g] * * *
1. Compute:
[GRAPHIC] [TIFF OMITTED] TP18DE01.017
Where:
m' = m, except for MBS credit rating below BBB where m'=120
R = MBS credit rating
* * * * *
3.8.1 * * *
[f] In a currency swap, the Enterprise receives payments that
are denominated in a foreign currency and it makes payments in U.S.
dollars. The main difference between currency swaps and the type of
swaps discussed above is that in a currency swap principal amounts
are actually exchanged between the two counterparties. Currency
swaps are divided into two classes, as shown in Table 3-65 below.\5\
---------------------------------------------------------------------------
\5\ Ibid.
Table 3-65--Currency Swap Contract Classification
----------------------------------------------------------------------------------------------------------------
Classification Description of Contract
----------------------------------------------------------------------------------------------------------------
Fixed-for-Fixed Currency Swap Enterprise receives fixed interest payments denominated in a foreign
currency and makes fixed, US$-denominated payments
----------------------------------------------------------------------------------------------------------------
Fixed-for Floating Currency Swap Enterprise receives fixed interest payments denominated in a foreign
currency and makes payments in US$ based on a floating interest rate
----------------------------------------------------------------------------------------------------------------
* * * * *
3.8.3.1 * * *
[a] * * *
3. When applying the option exercise rule:
a. For zero coupon and discount securities, instruments with
European options, and zero coupon swaps, evaluate option exercise
only on dates listed in the instrument's option exercise schedule.
For Bermudan options, evaluate option exercise on the first option
date in the instrument's option exercise schedule and subsequent
coupon dates (coupon dates on the fixed-rate leg for swaps). For
American options, evaluate option exercise on the first option date
in the instrument's option exercise schedule and subsequent monthly
anniversaries of the instrument's first coupon date.
* * * * *
3.8.3.10 * * *
[a] Finally, the interest and principal cash flows received by
the Enterprises for non-mortgage instruments other than swaps and
foreign currency-related instruments are Haircut (i.e., reduced) by
a percentage to account for the risk of counterparty insolvency, if
a counterparty obligation exists. The amount of the Haircut is
calculated based on the public rating of the counterparty and time
during the stress period in which the cash flow occurs, as specified
in section 3.5, Counterparty Defaults, of this Appendix.
[b] An Enterprise may issue debt denominated in, or indexed to,
foreign currencies, and eliminate the resulting foreign currency
exposure by entering into currency swap agreements. The combination
of the debt and the swap creates synthetic debt with principal and
interest payments denominated in U.S. dollars. The Haircuts for
currency swaps are applied to the pay (dollar-denominated) side of
the currency swaps, or to the cash outflows of the synthetic debt
instrument. Therefore, the payments made by the Enterprise on a
foreign currency contract are increased by the haircut amount. The
Haircuts and the Phase-in periods for currency swaps are detailed in
Table 3-31, under Derivative Contracts.
[c] Haircuts for swaps that are not foreign currency related are
applied to the Monthly Interest Accruals (as calculated in section
3.8.3.8, of this Appendix) on the receive leg minus the Monthly
Interest Accruals on the pay leg when this difference is positive.
Use the maximum haircut from Table 3-31 for periods before and after
the implementation of netting, as appropriate. After the
implementation of netting, net the swap proceeds for each
counterparty before applying the haircuts. The following example
applies to an Enterprise having two swaps with the same
counterparty. On the first swap, the Enterprise pays fixed and
receives floating and on the second swap it pays floating and
receives fixed. If the counterparty is a net payer to the
Enterprise, the haircuts will be applied to the sum of the two
receive legs net of the sum of the two pay legs.
* * * * *
3.10.3.1 * * *
[b] * * *
2. In any month in which the cash position is negative at the end of
the month, the Stress Test issues a mix of new short-term and long-
term debt on the 15th day of that month. New short-term debt issued
is six-month discount notes with a discount rate at the six-month
Enterprise Cost of Funds as specified in section 3.3, Interest
Rates, of this Appendix, with interest accruing on a 30/360 basis.
New long-term debt issued is five-year bonds not callable for the
first year (``five-year-no call-one'') with an American call at par
after the end of the first year, semiannual coupons on a 30/360
basis with principal paid at maturity or call, and a coupon rate set
at the five year Enterprise Cost of Funds as specified in section
3.3, Interest Rates, of this Appendix, plus a 50 basis point premium
for the call option. An issuance cost of 2.5 basis points is
assessed on new short-term debt at issue and an issuance cost of 20
basis points is assessed on new long-term debt at issue. New long-
term debt is issued to target a total debt mix of short to long term
debt that is the same as the short to long term debt mix at the
beginning of the Stress Test. Issuance fees for new debt are
amortized on a straight line basis to the maturity of the
appropriate instrument.
3. Given the Net Cash Deficit (NCDm) in month m, use the
following constants and method to calculate the amount of short-term
and long-term debt to issue in month m:
a. Set the Issuance Cost on new short-term debt at issue
(ISCOST):
ISCOST = 0.00025
b. Set the Issuance Cost on new long-term debt at issue
(ILCOST):
ILCOST = 0.002
c. Calculate Net Short-term Debt Outstanding (NSDO0)
and Total Debt Outstanding (TDO0) at the start of the
[[Page 65162]]
Stress Test (m = 0) using the following methodology:
(1) For each month m and each debt and swap instrument i (each
swap leg is considered a separate instrument), determine the Month
of Next Repricing (MNRm) defined as the first month
greater than m in which the instrument matures, an option is
exercised, or repricing can occur whether or not the coupon rate
actually changes. Set the Principal Balance (PBm) to be:
(a) the principal (or notional principal) outstanding if the
instrument cash flows are paid by the Enterprise,
(b) minus the principal (or notional principal) outstanding if
the instrument cash flows are received by the Enterprise.
(2) Calculate NSDOm by summing PBm,i for
all instruments where MNRm,i is less than or equal to m
plus 12.
(3) Calculate TDOm by summing PBm,i for
instruments where MNRm,i is greater than m.
d. Set the Maximum Proportion of Total Debt (MPD):
[GRAPHIC] [TIFF OMITTED] TP18DE01.018
e. Calculate Discount Rate Factor (DRFm):
[GRAPHIC] [TIFF OMITTED] TP18DE01.019
Where: CFm = six month Enterprise Cost of Funds for month
m
f. Calculate the Adjustment Factor for Short-Term Debt Issuance
Fees (AFSIFm):
[GRAPHIC] [TIFF OMITTED] TP18DE01.020
g. Calculate the Adjustment Factor for Long-Term Debt Issuance
Fees (AFLIFm):
[GRAPHIC] [TIFF OMITTED] TP18DE01.021
h. Calculate the Maximum Long-Term Issuance (MLTIm):
[GRAPHIC] [TIFF OMITTED] TP18DE01.022
i. Calculate Net Short-Term Debt Outstanding (NSDOm)
and Total Debt Outstanding (TDOm) for month m using the
methodology described in section 3.c. of this section. Note: This
calculation must reflect all new issuances, option exercises, and
maturities between the beginning of the Stress Test and month m.
j. Calculate Interim Face Amount of Long-Term Debt to be issued
this month (IFALDm):
[GRAPHIC] [TIFF OMITTED] TP18DE01.023
k. Calculate Face Amount of Long-Term Debt to be issued
(FALDm):
[GRAPHIC] [TIFF OMITTED] TP18DE01.024
l. Calculate Face Amount of Short-Term Debt to be issued
(FASDm):
[GRAPHIC] [TIFF OMITTED] TP18DE01.025
* * * * *
3.10.3.6.2 * * *
[a] * * *
5. Fixed Assets. 25 percent of fixed assets (net of accumulated
depreciation) as of the beginning of the Stress Test remain constant
over the Stress Test. The remaining 75 percent is converted to cash
on a straight line basis over the ten-year Stress Period.
Depreciation is included in the base on which operating expenses are
calculated for each month during the Stress Period.
* * * * *
4.0 * * *
Enterprise Cost of Funds: Cost of funds used in computing the
cost of new debt for the Enterprises during the Stress Test, as
specified in section 3.3.3[a]3.c., of this Appendix.
* * * * *
Dated: December 11, 2001.
Armando Falcon, Jr.,
Director, Office of Federal Housing Enterprise Oversight.
[FR Doc. 01-30898 Filed 12-17-01; 8:45 am]
BILLING CODE 4220-01-P