OFHEO's Risk-Based Capital Stress Test
Incorporating New Business Is Not Advisable Gao ID: GAO-02-521 June 28, 2002GAO reviewed whether the Office of Federal Housing Enterprise Oversight (OFHEO) should incorporate new business assumptions into the stress test used to establish risk-based capital requirements. The stress test is designed to estimate, for a 10-year period, how much capital the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) would be required to hold to withstand potential economic shocks, such as sharp movements in interest rates or adverse credit conditions. Incorporating new business assumptions into the stress test would mean specifying details about the types and quality that would be acquired during the 10-year stress period, the types of funding that would be used to acquire such mortgages, and other operating and financial strategies that would be implemented by Fannie Mae's and Freddie Mac's managements. GAO found that data for the enterprises show that new business conducted over a 10-year period accounts for a large share of their on- and off-balance sheet holdings of assets and liabilities at the end of each 10-year period. Because new business represents such a large share of enterprise holdings over time, it would have a major impact on the enterprises' financial condition, risks, and capital adequacy in the face of stressful events. However, determining the appropriate new business assumptions to include in the model would be difficult and inherently speculative. with OFHEO having to develop plausible scenarios for how enterprise management and the market would respond in a stressful environment. OFHEO can use supervisory review, which includes examination of the enterprises' ongoing business activities and enforcement actions, and should work in conjunction with the capital requirement to help ensure the safety and soundness of the enterprises.
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Director: Team: Phone:GAO-02-521, OFHEO's Risk-Based Capital Stress Test: Incorporating New Business Is Not Advisable
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United States General Accounting Office:
GAO: Report to Congressional Committees:
June 2002: OFHEO‘s Risk-Based Capital Stress Test: Incorporating New
Business Is Not Advisable:
GAO-02-521:
Contents:
Letter:
Results in Brief:
Background:
New Business Has a Substantial Impact on the Enterprises‘ Financial
Health, Level of Risks, and Capital Adequacy:
Incorporating New Business Assumptions Is Difficult and Inherently
Speculative:
Supervisory Review Can Be Another Effective Tool for Limiting the
Potential Risks of New Business:
Conclusions:
Recommendation:
Agency Comments and Our Evaluation:
Appendix I: HUD Regulates the Enterprises‘ Housing Goal Requirements:
Appendix II: The Business of the Enterprises:
Appendix III: Comments from Freddie Mac:
Related GAO Products:
Tables:
Table 1: Enterprise Purchases of Single-Family Mortgages Compared with
Originations and the Prior Year‘s Mortgage Portfolio, 1991-2000:
Table 2: Selected Enterprise On-Balance Sheet Holdings and Liabilities
as of December 31, 2001:
Table 3: Total Mortgage Portfolio of the Enterprises, Year-End 2001:
Table 4: Selected Data on Enterprise Income and Expenses for the year
ending December 31, 2001:
Abbreviations:
HUD: Department of Housing and Urban Development
MBS: mortgage-backed securities
FCA: Farm Credit Administration
FHFB: Federal Housing Finance Board
FHLBank: Federal Home Loan Bank
GSE: Government-Sponsored Enterprise
OFHEO: Office of Federal Housing Enterprise Oversight
PCA: Prompt Corrective Actions:
June 28, 2002:
Congressional Committees:
This report responds to a mandate in the Federal Housing Enterprises
Financial Safety and Soundness Act of 1992 (the act)[Footnote 1] that
we study whether the Office of Federal Housing Enterprise Oversight
(OFHEO) should incorporate new business assumptions into the stress
test used to establish risk-based capital requirements. The stress test
is designed to estimate, for a 10-year period, how much capital the
Federal National Mortgage Association (Fannie Mae) and the Federal Home
Loan Mortgage Corporation (Freddie Mac) would be required to hold to
withstand potential economic shocks, such as sharp movements in
interest rates or adverse credit conditions.[Footnote 2] Incorporating
new business assumptions into the stress test would mean specifying
details about the types and quality of new mortgages that would be
acquired during the 10-year stress period, the types of funding that
would be used to acquire such mortgages, and other operating and
financial strategies that would be implemented by Fannie Mae‘s and
Freddie Mac‘s (the enterprises) managements. Under the terms of the
act, the current test assumes that the enterprises do not contract for
any new business beyond what is on the books at the time of the test.
OFHEO issued its risk-based capital rule on September 13,
2001.[Footnote 3] Four years after issuing its risk-based capital rule,
OFHEO has the option to incorporate new business assumptions into the
test. Our mandate is to provide, within the first year after the rule
is issued, an opinion on the advisability of including new business
after the initial 4-year period.[Footnote 4]
As agreed with your offices, our objectives were to (1) analyze the
effects that new business could have on the enterprises‘ financial
condition and capital adequacy; (2) analyze the challenges of
incorporating new business assumptions into the stress test, including
any potentially adverse consequences; and (3) consider the efficacy of
using supervisory review in conjunction with the current stress test to
address the potential risks associated with new business.
To complete our work, we reviewed (1) the 1992 act and its legislative
history; (2) enterprise capitalization studies conducted by the
Department of Housing and Urban Development (HUD) prior to OFHEO‘s
establishment; (3) OFHEO‘s current risk-based capital regulation and
public comments made on previously proposed risk-based capital rules;
(4) historic financial data pertaining to the balance sheets and new
business activities of the enterprises; (5) each enterprise‘s risk-
management practices and financial models used for planning and risk-
management purposes; and (6) related literature. We did not verify
financial data on the enterprises or provided by OFHEO, nor did we
review the mechanics of the OFHEO stress test model. We also
interviewed officials from the enterprises, HUD, OFHEO, and rating
agencies, as well as individuals engaged in developing risk-based
capital models for financial institutions. Our scope was limited to our
study mandate and its focus on new business assumptions, so we did not
make an overall evaluation of OFHEO‘s current risk-based capital rule
or stress test, except as they directly applied to our study mandate.
We conducted our work in Washington, D.C., between September 2001 and
April 2002, in accordance with generally accepted government auditing
standards.
Results in Brief:
New business is an important determinant of the expected future
financial
condition of both Fannie Mae and Freddie Mac. Data for the enterprises
show that new business conducted over a 10-year period generally
accounts
for a large share of their on- and off-balance sheet holdings of assets
and liabilities at the end of each 10-year period. Because new business
represents such a large share of enterprise holdings over time, it
would
have a major impact on the enterprises‘ financial condition, risks, and
capital adequacy in the face of stressful events.
However, determining the appropriate new business assumptions to
include in OFHEO‘s model would be difficult and inherently speculative.
To incorporate new business assumptions, OFHEO would have to develop
plausible scenarios for how enterprise management and the market would
respond in a stressful environment. For instance, OFHEO would need to
consider management‘s capacity, not only to make appropriate
adjustments in the face of uncertainty but, it would also have to make
assumptions about actions the enterprises might take to improve their
financial condition. Another factor to consider would be HUD‘s
regulatory behavior during periods of stress, because the Secretary of
HUD has exclusive authority to promulgate and enforce numeric housing
goals for the enterprises. The fact that the enterprises do not
incorporate new business assumptions into their own long-term capital
adequacy models illustrates the difficulties involved. The enterprises
generally incorporate new business assumptions only into financial
models for relatively short-term planning (4 years or less). In
addition, incorporating new business assumptions would increase the
complexity of OFHEO‘s already complex stress test, making it more
difficult to understand and replicate. Because of the importance of new
business and the speculative nature of any assumptions about enterprise
behavior, the assumptions required could dominate the capital
requirement.
OFHEO has another tool it can use to limit risk taking by the
enterprises. Supervisory review, which includes examination of the
enterprises‘ ongoing business activities and enforcement actions,
should work in conjunction with the capital requirement to help ensure
the safety and soundness of the enterprises. OFHEO is authorized to
take actions to limit risk taking when an enterprise‘s financial
condition is jeopardized. Financial regulators tend to rely on
supervisory review to respond when specific practices occur that could
pose a safety and soundness concern.
This report contains a recommendation to the director of OFHEO that the
agency not incorporate new business assumptions into its stress test,
because determining the assumptions is inherently speculative and
including them would introduce more complexity to an already complex
model.
Background:
Congress established and chartered the enterprises”Fannie Mae and
Freddie Mac”as government-sponsored enterprises (GSE) that are
privately owned and operated. Their mission is to enhance the
availability of mortgage credit across the nation during both good
and bad economic times by purchasing mortgages from lenders (banks,
thrifts, and mortgage bankers) that use the proceeds to make additional
mortgage loans to home buyers. The enterprises issue debt to finance
some of the mortgage assets they retain in their portfolios. Most
mortgages purchased by the enterprises are conventional mortgages,
which have no federal insurance or guarantees. Enterprise purchases
are subject to a conforming loan limit [Footnote 5] that currently
stands at $300,700 for a single-unit home.
The debt and mortgage assets in the enterprises‘ portfolios are on-
balance sheet obligations (liabilities) and assets, respectively. A
majority of the mortgages, however, are placed in mortgage pools to
support mortgage-backed securities (MBS) that may be sold to investors
or repurchased by the enterprises and held in their portfolios. MBS are
conduits for collecting principal and interest payments from mortgages
in the mortgage pools and passing payments onto MBS investors. The
enterprises charge fees for guaranteeing the timely payment of
principal and interest on MBS held by investors. MBS held by investors
other than the enterprises are off-balance sheet obligations of the
enterprises.
The federal government‘s creation of and continued relationship with
Fannie Mae and Freddie Mac have created the perception in financial
markets that the government will not allow the enterprises to default
on their debt and MBS obligations, although no such legal requirement
exists. As a result, Fannie Mae and Freddie Mac can borrow money in the
capital markets at lower interest rates than comparably creditworthy
private corporations that do not enjoy federal sponsorship. At least a
portion of the financial benefits that accrue to the enterprises have
been passed along to homeowners in the form of lower mortgage interest
rates.
During the 1980s, the government did provide limited regulatory and
financial relief to Fannie Mae when the enterprise was experiencing
significant financial difficulties; and in 1987, Congress authorized $4
billion to bail out the Farm Credit System, another GSE. Recognizing
the potentially large costs that Fannie Mae and Freddie Mac pose to
taxpayers, Congress passed the act, which established OFHEO as an
independent regulator within HUD--tasked with ensuring the enterprises‘
safety and soundness. OFHEO‘s director has broad independent authority
to ensure that OFHEO fulfills its safety and soundness mission. For
example, the director has the authority to take supervisory and
enforcement actions regarding the safety and soundness of the
enterprises without the review and approval of the Secretary of HUD.
The act requires OFHEO to carry out its oversight function both by
establishing and enforcing minimum capital standards (including the
risk-based capital standard) and by conducting annual on-site safety
and soundness examinations of the enterprises to assess their
operations and financial condition. The act established the broad
outlines of a stress test and mandated that OFHEO develop its stress
test within those parameters to serve as the basis for the risk-based
capital standards.[Footnote 6] The act requires the stress test to
simulate situations that expose the enterprises to extremely adverse
credit and interest rate scenarios over a 10-year period and to
calculate the cash flows and the amount of capital the enterprises
would need to continue to operate for the entire period. The stress
test model must include upward and downward interest rate movements of
up to 6 percentage points and assume a high level of credit risk (based
on the worst cumulative credit loss for not less than 2 consecutive
years in contiguous states encompassing at least 5 percent of the U.S.
population). As required in the act, the stress test model that the
agency developed estimates credit [Footnote 7] and interest
rate[Footnote 8] risks, among other factors, and includes an additional
30 percent of that amount for management and operations risk.[Footnote
9] Also as required, it does not include new business assumptions. The
act set a December 1, 1994, deadline for completion of the stress test
and risk-based capital standards.
HUD is the mission regulator of the enterprises. The Secretary of HUD
has general regulatory power over the enterprises to ensure that they
carry out their mission as stated in their charters. The act requires
the Secretary to establish annual goals for purchases of mortgages on
low-and moderate-income housing, special affordable housing, and
housing in central cities, rural areas, and other under-served areas.
When HUD establishes housing goals, it must look at several factors,
including the need for the enterprises to remain in sound financial
condition. For more information about HUD‘s mission regulation, see
appendix I.
New Business Has a Substantial Impact on the Enterprises‘ Financial
Health, Level of Risks, and Capital Adequacy:
The enterprises are in the business of buying and holding mortgages
and insuring mortgage cash flows to investors. New business accounts
for a large share of the enterprise‘s on- and off-balance sheet
holdings
and thus has a major impact on their activities and financial health.
The financial health of the enterprises and their ability to survive a
future stressful economic period depend on the level of risk in both
their existing and new business; the amount of capital that is
available
to them to absorb any losses”their capital adequacy; and the business
decisions they make during the stressful period.
New Business Affects the Enterprises‘ Financial Condition:
The enterprises continually acquire mortgages originated by lenders for
home purchases and for refinancing existing mortgages (see table 1).
Such mortgage acquisitions are a large share of total originations in
any
year and are often large relative to mortgage holdings at the end of
the
prior year. For example, the enterprises‘ purchases equaled between 32
and 51 percent of total single-family originations in each year between
1991 and 2000. [Footnote 10] In addition, their yearly purchases
between 1991 and 2000
ranged from about 17 to 51 percent of their total mortgage portfolios
in
the prior year [Footnote 11].
Table 1: Enterprise Purchases of Single-Family Mortgages Compared with
Originations and the Prior Year‘s Mortgage Portfolio, 1991-2000:
Dollars in millions.
Year: 1991; Total enterprise purchases: $233,280; Total originations:
$562,074; Enterprise purchases as a percentage of originations: 41.50;
Prior year‘s total enterprise mortgage portfolios: $740,020;
Enterprise
purchases as a percentage of prior year‘s portfolios: 31.52.
Year: 1992; Total enterprise purchases: 439,309; Total originations:
893,666; Dollars in millions: Enterprise purchases as a percentage of
originations: 49.16; Prior year‘s total enterprise mortgage portfolios:
867,793; Enterprise purchases as a percentage of prior year‘s
portfolios:
50.62.
Year: 1993; Total enterprise purchases: 518,877; Total originations:
1,019,861; Enterprise purchases as a percentage of originations: 50.88;
Prior year‘s total enterprise mortgage portfolios: 1,021,847;
Enterprise
purchases as a percentage of prior year‘s portfolios: 50.78.
Year: 1994; Total enterprise purchases: 280,792; Total originations:
773,121; Enterprise purchases as a percentage of originations: 36.32;
Prior year‘s total enterprise mortgage portfolios: 1,156,442;
Enterprise
purchases as a percentage of prior year‘s portfolios: 24.28.
Year: 1995; Total enterprise purchases: 215,974; Total originations:
639,436; Enterprise purchases as a percentage of originations: 33.78;
Prior year‘s total enterprise mortgage portfolios: 1,240,987;
Enterprise
purchases as a percentage of prior year‘s portfolios: 17.40.
Year: 1996; Total enterprise purchases: 287,306; Total originations:
785,329; Enterprise purchases as a percentage of originations: 36.58;
Prior year‘s total enterprise mortgage portfolios: 1,332,849;
Enterprise
purchases as a percentage of prior year‘s portfolios: 21.56.
Year: 1997; Total enterprise purchases: 275,081; Total originations:
859,100; Enterprise purchases as a percentage of originations: 32.02;
Prior year‘s total enterprise mortgage portfolios: 1,445,591;
Enterprise
purchases as a percentage of prior year‘s portfolios: 19.03.
Year: 1998; Total enterprise purchases: 618,410; Total originations:
1,470,000; Enterprise purchases as a percentage of originations: 42.07;
Prior year‘s total enterprise mortgage portfolios: 1,536,258;
Enterprise
purchases as a percentage of prior year‘s portfolios: 40.25.
Year: 1999; Total enterprise purchases: 548,748; Total originations:
1,275,000; Enterprise purchases as a percentage of originations: 43.04;
Prior year‘s total enterprise mortgage portfolios: 1,786,598;
Enterprise
purchases as a percentage of prior year‘s portfolios: 30.71.
Year: 2000; Total enterprise purchases: 395,082; Total originations:
1,048,000; Enterprise purchases as a percentage of originations: 37.70;
Prior year‘s total enterprise mortgage portfolios: 2,062,943;
Enterprise
purchases as a percentage of prior year‘s portfolios: 19.15.
Source: OFHEO.
[End of table]
At the end of 2001, Fannie Mae‘s total mortgage portfolio was $1.56
trillion and Freddie Mac‘s $1.14 trillion, of which $705 billion and
$492 billion, respectively, represented on-balance sheet mortgages. For
more information about the financial performance of the enterprises,
see appendix II.
New Business Affects the Enterprises‘ Level of Risk:
The enterprises face two primary risks, which are modeled in OFHEO‘s
stress test: interest rate risk and credit risk. The degree of risk
depends on the enterprises‘ operating and managerial decisions as well
as on future economic factors such as interest rates, unemployment,
inflation, and economic growth. Although the enterprises can take risk-
management efforts to limit their exposure, the costs of these efforts
can reduce profits. Thus, risk management is usually associated with
both
a lower expected or average profit and reduced variability in profits
and
losses.
Effects of Interest Rate Risk:
Interest rate risk reflects both movements in interest rates and
management decisions about how to fund mortgage acquisitions. In
general for the enterprises, when market interest rates decline,
mortgage purchases increase as homeowners move and pay off or
refinance existing mortgages. Declining rates may also lower the
enterprises‘ funding costs. In contrast, rising market interest rates
create higher interest expenses for the enterprises as debt turns over.
Prolonged periods of rising interest rates typically lead to a slowdown
in prepayments and refinancing activity, because interest rates on new
mortgages are higher than those on most of the previously originated
mortgages.
If funding costs rise and existing on-balance sheet mortgages at old,
lower interest rates remain on the books, prolonged periods of losses
and capital erosion can occur. Enterprise management can use callable
debt [Footnote 12] and other financial instruments or strategies to
mitigate interest
rate risk and other potential losses. However, such managerial
decisions
will tend to lower future expected profits.
OFHEO‘s current stress test, which assumes no new business over a 10-
year period, simulates the impact of interest rate movements and
economic conditions on the behavior of borrowers whose mortgages are
held by the enterprises and therefore affect the enterprises‘ cash
flows. The model requires that the mortgage holdings wind down over the
10-year period. The extent to which existing business winds down shows
the importance of new business, because in practice the enterprises
would be acquiring new mortgages to replace lost mortgages during the
period.
In the stress test model, the remaining mortgage balance (and existing
business) depends on scheduled payments of principal, other
prepayments, and defaults. Prepayments are sensitive to interest rate
changes because lower rates accelerate prepayments and higher rates
depress them. Default losses are sensitive to economic conditions,
including loan-to-value ratios and seasoning,[Footnote 13] because
loans
with lower loan-to-value ratios and seasoned loans are less likely to
default.
OFHEO ran its model for us for a portfolio of newly originated 30-year
fixed-rate single-family mortgages[Footnote 14] with 95 percent loan-
to-value ratios. About 4.7 percent of a portfolio of newly originated
loans would still be on the enterprises‘ books after 10 years in the
declining interest rate environment mandated by the act. In the
increasing rate environment mandated by the act, about 57.3 percent of
a portfolio of newly originated loans would still be on the
enterprises‘ books after 10 years.[Footnote 15] OFHEO also ran the
model on other portfolios with different loan-to-value ratios and
degrees of seasoning, with similar results in both the declining and
increasing rate environments. As previously stated, in actual practice
the enterprises would replace many of the lost loans; and the types of
mortgages acquired and types of financial instruments actually used to
fund these new mortgages would significantly impact returns and risks.
Effects of Credit Risk:
Credit risk reflects both economic conditions and management decisions
about mortgage acquisitions. Deteriorating economic conditions can
lower home values and reduce homeowners‘ incomes, therefore increasing
credit risk. Likewise, management decisions to increase loan-to-value
ratios or otherwise ease underwriting standards can raise credit risk.
The OFHEO simulations also showed how the credit stresses in the
mandated increasing and decreasing rate environments could affect
credit-related losses. The simulations showed that, for a portfolio of
newly originated single-family mortgages with a 95 percent loan-to-
value ratio, defaults would account for a decline of about 19.5 percent
of the original mortgage balances in the decreasing rate environment
and a decline of about 16.2 percent of the original mortgage balances
in the increasing rate environment.
The enterprises could limit credit risk in several ways. For example,
they could use more stringent underwriting standards, although such
standards could limit the dollar volume of mortgages they are able to
purchase and possibly affect their ability to support the residential
mortgage market. For instance, requiring homeowners to make large down
payments or purchase private mortgage insurance could make acquiring a
mortgage more difficult for potential homeowners. Second, they could
more aggressively monitor loans and work out problems with troubled
loans. Third, the enterprises could mitigate the economic costs of
defaults by raising the management guarantee fee they charge mortgage
pools for providing credit insurance and managing the pools.
Ultimately, however, management actions to limit credit risk might
create expenses that would curtail expected future profits. Actual
decisions about underwriting, mortgage monitoring, and guarantee fees
would affect the returns and risks associated with the acquisition of
new mortgages by the enterprises.
New Business Affects the Enterprises‘ Capital Adequacy:
Under the risk-based capital test, capital adequacy measures the
amount of capital an enterprise needs to ensure that it can continue
to operate during a stressful period and is based on expected profits
and the risks taken to generate those profits. Generally speaking, risk
and profit are positively related. For example, an enterprise can
increase
its expected profits by taking more risks, but taking greater risks can
increase the possibility that the enterprise will not survive a
stressful
economic period due to losses incurred. An enterprise can increase its
chances of surviving a stressful period by increasing its capital
level,
but such increases raise funding costs and reduce future expected
profits.
Capital adequacy also depends on the extent and duration of the
economic
stress that the enterprise might encounter. The greater the levels of
stress
an enterprise must endure and the longer the exposure to stress, the
less
likely it is that the enterprise will survive the stress period with a
given
level of capital.
Incorporating New Business Assumptions Is Difficult and Inherently
Speculative:
Incorporating new business assumptions into long-term financial
planning
models is difficult, primarily because doing so is inherently
speculative.
Incorporating such assumptions would require OFHEO to develop plausible
scenarios for the future behavior of the enterprises”for example, the
types
of mortgages they might acquire, their future funding strategies, and
other
managerial decisions. In addition, OFHEO would have to consider HUD‘s
regulatory actions and their effect on the enterprises during the
stress
period. The difficulty of incorporating new business assumptions into a
stress test is reflected in the fact that the enterprises do not
include
such assumptions in their own long-term capital adequacy models. The
enterprises
generally use new business assumptions only in models with relatively
short
time frames (up to 4 years). Finally, OFHEO‘s stress test is already
highly
complex. Adding new business assumptions would increase its complexity
and make
the legal requirement that it be replicable more difficult to meet.
OFHEO‘s Assumptions about the Behavior of Management Would Be
Speculative:
An OFHEO stress test with new business assumptions would have to
include
explicit assumptions about the enterprises‘ strategic managerial
behavior
in a stressful economic environment. Management‘s behavior would have
to be
linked to hedging, which affects interest rate risk; underwriting,
which
affects credit risk; and setting guarantee fees, which affect earnings.
Specifying management‘s behavior would be speculative, unlike the
modeling
of borrowers‘ behavior in the stress test. Borrowers‘ behavior related
to
mortgage prepayment and default can be and is predicted in the stress
test,
based on statistical techniques that are applied to historic data.
Although
this prediction is subject to statistical measurement errors, these
techniques
can be used to extrapolate borrower behavior in a stressful
environment.
However, because managerial behavior is idiosyncratic, such techniques
cannot be used to extrapolate managerial behavior in a stressful
environment
from behavior in more normal economic environments. For instance,
overall
management strategies dealing with both interest rate and credit risks
could either exacerbate risk exposures or mitigate such risks to
various
degrees. OFHEO would lack criteria, both statistical and theoretical,
to
justify assumptions about these strategies. Therefore, OFHEO would have
to speculate about managerial behavior to develop new business
assumptions.
In addition, because a significant proportion of the enterprises‘
mortgages
either prepay or default over a 10-year period and are replaced by new
business, the assumptions about new business could easily dominate the
cash and capital flows in the stress test over the 10-year period.
These
assumptions could also determine whether the enterprises met or failed
to
meet the risk-based capital requirement.
In the legislative history of the act, Congress recognized that OFHEO
would have to hypothesize about any new business assumptions that might
be included in a stress test. Language in a Senate committee report
explicitly recognized that incorporating new business assumptions
during a stressful period would require speculating about enterprise
behavior. The report recognized that any assumptions addressing new
business in the stress test would also have to incorporate further
assumptions about enterprise management‘s capacity to make suitable
adjustments.[Footnote 16]
The act requires the director to assume that the new business the
enterprises conduct during the stress period will be consistent with
either historic or recent experience and with the economic
characteristics of the stress period. In particular, the director must
make specific assumptions about five factors:
* the amounts and types of business,
* losses,
* pricing,
* interest rate risk, and:
* reserves.
These restrictions limit OFHEO‘s modeling assumptions, allowing for
managerial response only after the advent of the stressful condition
and requiring that the responses be consistent with the prior behavior
of the enterprise. In other words, for purposes of the stress test
OFHEO cannot assume that management will take actions in anticipation
of stressful conditions, that management will be able to respond
differently than it has previously under similar circumstances, or that
management will respond promptly and effectively to stressful
situations to maintain adequate capital.
OFHEO Would Need to Consider HUD‘s Regulatory Response to the
Enterprises‘ Housing Goals:
In addition to speculating about the behavior of the enterprises‘
management, OFHEO would need to consider HUD‘s regulatory response to
a stressful environment. HUD regulates the enterprises in terms of
housing goals and other charter requirements not directly concerned
with safety and soundness (see app. I for a detailed description of
HUD‘s regulatory responsibilities and powers). [Footnote 17] However,
when HUD establishes housing goals, it must look at several factors,
including the need for the enterprises to remain in sound financial
condition.
If either enterprise‘s financial condition should falter, the Secretary
of HUD would likely take regulatory actions to help the enterprise
rather than allow it to withdraw entirely from the secondary mortgage
market or from segments of the market governed by HUD‘s numeric goals.
For modeling purposes, OFHEO would have to consider both the regulatory
actions HUD might take to ensure that the enterprises continue to
comply with the housing goals and the effects of such actions on
management‘s approach to new business and risks. HUD‘s regulatory
response could have a further effect on the model by constraining the
enterprises and thus affecting managerial decisions at the enterprises.
New Business Assumptions Are Not Included in Fannie Mae‘s Long-Term
Financial Modeling or Freddie Mac‘s Modeling for Capital Adequacy:
The enterprises do not include new business in their long-term
financial
models (Fannie Mae) or in their capital adequacy models (Freddie Mac)
because
they believe that such assumptions would be speculative. [Footnote 18]
Fannie
Mae officials told us that it would not be reasonable to make new
business
assumptions beyond a window of several years, and the results of such a
modeling approach might be more reflective of the assumptions
themselves
than of the actual risks faced by Fannie Mae. Freddie Mac‘s interest
rate
risk exposure is stated in terms of portfolio market value sensitivity,
or the estimated percentage decline in Freddie Mac‘s market value of
equity that results from a change in interest rates. Freddie Mac
officials
told us that another reason they do not include new business in their
risk
models is that they want to focus on the risks of the current book of
business and not the profitability of new business. Although OFHEO
probably
would not rely solely on the enterprises‘ assumptions about new
business,
in the absence of such assumptions, OFHEO would still have to make
plausible
assumptions about the enterprises‘ behavior.
The enterprises do include new business assumptions in the short-term
models used to manage business on a day-to-day basis and for planning.
The enterprises‘ short-term planning models typically focus on business
strategies during time periods of no more than 4 years under economic
stresses that are relatively normal compared with those in OFHEO‘s
stress test. Some of these models used to analyze interest rate risk
include new business assumptions.
Other Entities Generally Do Not Incorporate New Business Assumptions
When Evaluating Long-Term Capital Adequacy:
Our review of information from regulators and three rating agencies
(Standard
& Poor‘s, Moody‘s, and Fitch) indicates that these entities do not use
new
business assumptions when evaluating the capital adequacy of financial
institutions. For example, the Federal Housing Finance Board (FHFB) has
issued risk-based capital standards for the other housing GSE, the
Federal
Home Loan Bank (FHLBank) System. FHFB developed an approach based on
the
existing balance sheet that estimates the market value of the FHLBank‘s
portfolio at risk under financial stress scenarios and thus does not
require an assumption about new business. As another example,
depository
institution regulators have established capital requirements for credit
risk that assign all existing assets and off-balance sheet items to
broad
categories of relative risk; and they do not incorporate new business
assumptions.
In addition, Standard & Poor‘s, Moody‘s, and Fitch use no new business
in their
stress tests for rating private mortgage insurers. [Footnote 19]
During our review, we identified one instance in which new business
assumptions are included in a risk-based capital stress test. The Farm
Credit Administration (FCA) has established risk-based capital
standards for Farmer Mac, a relatively small GSE operating in the
secondary market for agricultural mortgages. FCA includes replacement
of paid-off agricultural mortgages in its 10-year stress test
model.[Footnote 20]
Including New Business Assumptions Would Add Complexity to OFHEO‘s
Stress Test and Make It Difficult to Replicate:
The unique nature of OFHEO‘s risk-based standard, particularly the 10-
year
time frame and the specificity regarding stresses, makes the OFHEO
stress
test complex. Adding new business assumptions would increase this
complexity
by introducing more factors that could affect the behaviors modeled
within
the stress test and requiring that more behaviors be modeled. [Footnote
21]
Adding more complexity would further limit the ability of analysts and
others
to understand and replicate the test, as the 1992 act requires.
[Footnote 22]
For example, the test would likely require refinements to take into
account the
dynamic behaviors of borrowers, investors in enterprise debt and MBS,
and the
enterprises over the 10-year period. These behaviors include shifts in
borrower
demand for fixed- and adjustable-rate mortgages, investors‘ willingness
to take on
the risk of alternative funding sources for the enterprises, and the
enterprises‘
mortgage purchase and funding strategies. According to enterprise
officials, the
ability of individuals outside of OFHEO to understand and replicate the
current
stress test is already strained, even without new business assumptions.
The
inclusion of new business assumptions to predict the behaviors of
parties such
as the mortgage originators, mortgage borrowers, investors, and the
enterprises
would exacerbate this situation.
New Business Assumptions Could Dominate the Capital Requirement Under
the Stress Test:
To incorporate new business assumptions into its stress test, OFHEO
could
develop plausible scenarios for how enterprise management and the
market might
respond in a stressful environment, but depending on the assumptions,
the
capital requirement could be increased or decreased. The assumptions
could
dominate the capital requirement. In the early 1990s, for example,
prior to
the creation of OFHEO, HUD analyzed each enterprise‘s capitalization
using a
stress test that incorporated a Depression scenario. [Footnote 23]
HUD‘s analyses
showed that incorporating new business resulted in higher capital
requirements
for the enterprises. HUD made two major assumptions that affected the
result.
First, HUD assumed that the enterprises would have difficulty
determining
exactly when a downturn would begin and projecting its length and
severity.
This assumption limited management‘s ability to mitigate risk. Second,
HUD
assumed that the enterprises would be required to provide ongoing and
meaningful
support to the secondary mortgage market during a prolonged period of
severe
economic conditions; and therefore, the enterprises could not stop
purchasing
mortgages that might generate losses in a stressful environment.
Other plausible scenarios could lead to assumptions showing that
incorporating new business might mitigate risk and improve capital
adequacy. According to Fannie Mae officials, for example, including new
business using the enterprises‘ current underwriting standards and
guarantee fees would result in a lower capital requirement. The
officials pointed out that in a falling interest rate environment, the
credit quality of an existing mortgage portfolio would typically
decline as the less risky mortgages are refinanced and the more risky
ones remain. Including new business that encompasses the newly
refinanced mortgages would lower credit risk and thus result in a lower
capital requirement. An alternative plausible set of assumptions
showing that incorporating new business might mitigate risk and improve
capital adequacy could presume that the enterprises would change their
business practices to reduce risks in a stressful environment. For
example, during a stressful period, the enterprises might implement
stricter underwriting standards and increase their guarantee fees in
reaction to possible declines in mortgage credit quality.
Supervisory Review Can Be Another Effective Tool for Limiting the
Potential Risks of New Business:
While OFHEO‘s risk-based capital requirement is a key element in
ensuring
the enterprises‘ financial safety and soundness, other mechanisms also
exist
to limit risk taking by the enterprises. The proposed Basle Accord
revisions,
which address banking supervision, list the three ’mutually reinforcing
pillars“ that help ensure the financial safety and soundness of banks.
These
pillars”risk-based capital requirements (discussed in this report),
market
discipline, and supervisory review” should also be used to address
safety
and soundness oversight of the enterprises. Based on our work on bank
and
GSE safety and soundness supervision and our review of the proposed
Basle
Accord revisions, we have concluded that capital regulation in
isolation does
not provide sufficient oversight.
Market discipline can curb risky behavior by the enterprises to the
extent that the enterprises‘ customers and creditors will demand that
the enterprises stay fiscally strong in order to fulfill their
obligations. Market discipline works best when firms fully and publicly
disclose their financial conditions. Customers and creditors can then
use the information to determine further interactions with the
enterprises. In October 2000, the enterprises adopted six voluntary
commitments aimed at increasing their disclosures. The commitments
included, among other things, the issuance of subordinated debt and
public disclosure of financial information. Enterprise officials stated
that these commitments would improve transparency and market discipline
because market participants could use the added information to better
assess the financial condition of the enterprises. We acknowledge that
financial disclosure as mandated by the voluntary accord may improve
transparency. However, its impact on the enterprises and their
customers or funding parties is limited if the enterprises are
perceived to have implicit government backing. That is, other economic
parties may believe that the federal government will ensure that the
enterprises continue to operate and to perform satisfactorily on
financial contracts such as loans and mortgage purchases. For this
reason, while market discipline can play a role in curbing risky
behavior by the enterprises, it also has its limitations. Supervisory
review thus takes on more importance as a means for limiting
inappropriate risk-taking behavior by the enterprises.
The proposed revision of the Basle Accord recognizes the supervisory
review process as one of three ’pillars“ that contribute to safety and
soundness in the financial system. OFHEO‘s supervisory review includes
examining the operations of the enterprises and taking the supervisory
and enforcement actions necessary to ensure that the enterprises are
operating safely and soundly. In conjunction with other elements of
supervision, supervisory review can also help ensure that the
enterprises maintain sufficient capital to support the risks they
undertake. Further, it can encourage the enterprises to develop and use
better risk-management techniques to address the risks associated with
both existing and new business. Supervisory review can focus on
internal approaches to capital allocation and internal assessments that
reflect management‘s own expectations about future business
opportunities and risks without the need for OFHEO to impose its own
assumptions about new business.
In addition, supervisory review allows OFHEO to address the
enterprises‘ management structure and business approaches to ensure
that risk-management techniques and internal controls are appropriate
and are protecting the public interest. Risk-management practices that
sufficiently limit the credit and interest rate risks associated with
new business and adequate OFHEO supervision of those practices can
reduce the chances that an enterprise will take on risky new business
that could jeopardize its capital adequacy in a stressful economic
environment. For example, adequate supervision could inhibit an
enterprise‘s attempt to ’grow“ its way out of a problem situation in a
stressful environment by means such as lowering underwriting standards
or relaxing risk-management controls that address interest rate risk.
While adequate supervision is not guaranteed by the presence of OFHEO
and its legal authorities, inclusion of speculative new business
assumptions in the stress test--based on plausible managerial behavior-
-would not reduce the importance of adequate supervision.
OFHEO has several legal authorities that help in carrying out
supervisory responsibilities relating to safety and soundness. These
authorities include informal supervisory actions; formal enforcement
actions involving notice to the affected enterprise; hearing
opportunities; and, if warranted, imposition of sanctions such as cease
and desist orders or civil monetary penalties. The Federal Deposit
Insurance Corporation Improvement Act of 1991 mandates actions, known
as prompt corrective actions (PCA), that depository institution
regulators must take in response to specific capitalization levels.
Similarly, the 1992 act contains PCA provisions that authorize and,
depending on the level of undercapitalization, require OFHEO to take
certain actions when an enterprise is undercapitalized.[Footnote 24]
These mandates, which specify actions to be taken at certain levels of
undercapitalization, limit the possibility that OFHEO might be lenient
once an enterprise‘s capital cushion is impaired. OFHEO has issued
regulations implementing the PCA provisions and establishing prompt
supervisory responses to be taken based on specified noncapital
developments.[Footnote 25] The director of OFHEO has broad discretion
over measures that can be taken beyond these required actions. Such
discretionary powers allow the director of OFHEO to respond when
specific enterprise practices occur that could pose a safety and
soundness concern.
Conclusions:
Determining new business assumptions for inclusion in OFHEO‘s stress
test
is inherently speculative, and OFHEO would have to develop plausible
scenarios for managerial behavior to make such a determination. The
assumptions about new business could easily dominate the cash and
capital flows over the 10-year stress test period and therefore
dominate
the capital requirement. Thus, these assumptions could also determine
whether the enterprises met or failed to meet the risk-based capital
requirement. Adding new business assumptions would introduce more
complexity to an already complex model and interfere with the public
policy mandate that requires the model to be understandable and
replicable.
A stress test that concentrates on existing business rather than
potential
new business allows all parties to observe the risks embedded in
current
holdings and operations. In addition, OFHEO can use supervisory review
in conjunction with the stress test to help limit the potential risks
associated with new business.
Recommendation:
OFHEO should not incorporate new business assumptions into its risk-
based capital stress test. Appropriate examination and supervisory
review by the regulator can help ensure that the enterprises maintain
capital appropriate to the financial stresses they are experiencing
with regard to new business.
Agency Comments and Our Evaluation:
We requested comments on a draft of this report from the heads, or
their
designees, of Freddie Mac, Fannie Mae, and OFHEO. Freddie Mac‘s written
comments, which agreed with our conclusions and recommendation, appear
in appendix III. Fannie Mae and OFHEO provided technical comments that
were incorporated where appropriate. OFHEO officials also stated that
OFHEO does not model or predict enterprise behavior in its current
stress test, but does make assumptions to project enterprise behavior
in a stylized way, consistent with the stress conditions. For example,
they cited assumptions about enterprise new debt issues and operating
expenses in the current stress test. Such assumptions, they stated,
are necessary for a capital requirement that is appropriately sensitive
to risk. The OFHEO officials stated that incorporating new business
into the stress test would entail making assumptions that address
additional complicated managerial decisions on the full range of
enterprise activities. They added that, in contrast to the assumptions
that project managerial behavior in the current stress test, the
assumptions necessary to incorporate new business have the potential
to unduly influence the capital requirement and make it less sensitive
to current risks.
We made revisions based on OFHEO‘s comments distinguishing between
modeling or predicting enterprise behavior and developing reasonable
assumptions for enterprise management. We agree with OFHEO officials
that, compared to the current stress test, incorporating new business
into the stress test would require assumptions that address additional
complicated managerial decisions on the full range of enterprise
activities. Our report notes, in particular, that the assumptions
required to incorporate new business could dominate the capital
requirement.
We will send copies of this report to the Director of OFHEO, the Chief
Executive Officer of Fannie Mae, and the Chief Executive Officer of
Freddie Mac. We will also make copies available to others upon request.
Please contact William Shear or me at (202) 512-8678 if you or your
staff have any questions concerning this report. Key contributors to
this report were Mitchell Rachlis, Darleen Wall, Paul Thompson, and
Emily Chalmers.
Thomas J. McCool
Managing Director
Financial Markets and
Community Investment:
Signed by Thomas J. McCool.
List of Congressional Committees:
The Honorable Paul S. Sarbanes
Chairman:
The Honorable Phil Gramm
Ranking Minority Member:
Committee on Banking, Housing,
and Urban Affairs
United States Senate:
The Honorable Michael G. Oxley
Chairman:
The Honorable John J. LaFalce
Ranking Minority Member:
Committee on Financial Services
House of Representatives:
The Honorable Richard Baker
Chairman:
The Honorable Paul Kanjorski
Ranking Minority Member:
Subcommittee on Capital Markets, Insurance,
and Government Sponsored Enterprises
Committee on Financial Services
House of Representatives:
[End of section]
Appendix I HUD Regulates the Enterprises‘ Housing Goal Requirements:
Except for matters under the Office of Federal Housing Enterprise
Oversight‘s (OFHEO) exclusive authority, which relate primarily to
enterprise safety and soundness, the Secretary of the Department of
Housing and Urban Development (HUD) has general regulatory power
over the enterprises to ensure that they carry out the purposes of
their charters. [Footnote 26] These purposes include (1) providing
ongoing assistance to the secondary market for residential mortgages
allowing for mortgages on housing for low- and moderate-income families
involving lower returns than those earned on other activities and (2)
promoting access to mortgage credit throughout the nation, including
in central cities, rural areas, and underserved areas. Moreover, the
act requires the Secretary to establish annual goals for the
enterprises‘ purchases of mortgages on low- and moderate-income
housing; special affordable housing (housing for low-income families
in low-income areas and for very low-income families); and housing
in central cities, rural areas and other underserved areas. [Footnote
27]
Based on the regulatory scheme established in the act, the Secretary of
HUD could exercise these authorities during a stressful period in
a way that might affect an enterprise‘s new business. For example,
housing goals would require an enterprise to conduct new business.
Forecasting these goals and the potential for other mission-related
requirements and their impact on new business would be speculative.
The charter for each enterprise states that the purpose of the
enterprise is:
* to provide stability in the secondary market for residential
mortgages;
* to respond appropriately to the private capital market;
* to provide ongoing assistance to the secondary market for residential
mortgages (including activities relating to mortgages on housing for
low-and moderate-income families, involving a reasonable economic
return that may be less than the return earned on other activities) by
increasing the liquidity of mortgage investments and improving the
distribution of investment capital available for residential mortgage
financing; and:
* to promote access to mortgage credit throughout the nation (including
central cities, rural areas, and underserved areas) by increasing the
liquidity of mortgage investments and improving the distribution of
investment capital available for residential mortgage financing.
The numeric goals provisions of the 1992 act require the Secretary to
consider the following factors in setting final housing goals for each
of the three categories of housing: (1) national housing needs; (2)
economic, housing, and demographic conditions; (3) the performance and
effort of the enterprises in achieving the goals in previous years; (4)
the size of the conventional mortgage market serving targeted borrowers
relative to the size of the overall conventional mortgage market; (5)
the ability of the enterprises to lead the industry in making mortgage
credit available to targeted borrowers; and (6) the need to maintain
the sound financial condition of the enterprises.
Although the last factor requires consideration of an enterprise‘s
financial condition, nothing in the 1992 act suggests that the
Secretary should refrain from establishing goals or taking other
mission-related actions in the event of a stressful financial
condition. However, we believe that the Secretary would not exercise
mission and housing goal authorities in a way that would continue or
increase an enterprise‘s financial stress, because doing so would
undermine the financial safety and soundness requirements of the 1992
act and compromise the enterprise‘s ability to achieve its
mission.[Footnote 28]
[End of section]
Appendix II The Business of the Enterprises:
As table 2 shows, most of the enterprises‘ on-balance sheet assets
are mortgages. The table also shows that most of the mortgage and other
on-balance sheet financial activities of the enterprises are funded by
debt.
Table 2: Selected Enterprise On-Balance Sheet Holdings and Liabilities
as of December 31, 2001:
Dollars in millions.
Item: Retained mortgage portfolio, net; Fannie Mae: $705,167; Freddie
Mac: $491,719.
Item: Total assets; Fannie Mae: 799,791; Freddie Mac: 617,340.
Item: Debt, net; Fannie Mae: 763,467; Freddie Mac: 561,946.
Item: Total liabilities; Fannie Mae: 781,673; Freddie Mac: 601,967.
Item: Stockholders equity capital; Fannie Mae: 18,118; Freddie Mac:
15,373.
Sources: Enterprise Investor/Analyst Reports.
[End of table]
Each enterprise‘s total mortgage portfolio (see table 3) consists of
on-balance sheet mortgages and mortgage-backed securities (MBS) held by
the enterprises, and off-balance sheet MBS owned by investors who
receive their interest and principal from a pool of mortgages. At the
end of 2001, Fannie Mae‘s total mortgage portfolio was $1.56 trillion,
and Freddie Mac‘s was $1.14 trillion. A majority of the enterprises‘
holdings consisted of off-balance sheet MBS pools. Over time, both
enterprises have shifted a greater share of their mortgage assets on
book, increasing their interest rate risk.
Table 3: Total Mortgage Portfolio of the Enterprises, Year-End 2001:
Dollars in millions.
Mortgage assets, including MBS, on the balance sheet; Fannie Mae:
$705,167; Freddie Mac: $491,719.
Item: Mortgage-backed securities held by the public; Fannie Mae:
858,867; Freddie Mac: 646,448.
Item: Total mortgage portfolio; Fannie Mae: 1,564,034; Freddie Mac:
1,138,167.
Source: Enterprise Investor/Analyst Reports.
[End of table]
The enterprises‘ income and expenses reflect their basic operations.
Fannie Mae‘s 2001 net income was $5.9 billion and Freddie Mac‘s $4.1
billion, largely from net interest and fee income (see table 4).
Mortgages and MBS owned by the enterprises generated net interest
income of $8.1 billion for Fannie Mae and $5.5 billion for Freddie Mac,
while investor-owned MBS generated fee income that totaled about $1.6
billion for each enterprise. Actual and estimated expenses related to
credit risk were $77.7 million for Fannie Mae and $84 million for
Freddie Mac, while administrative expenses were about 17 percent of net
income for both enterprises.
Table 4: Selected Data on Enterprise Income and Expenses for the year
ending December 31, 2001:
Dollars in millions.
Item: Net income; Fannie Mae: $5,894.1; Freddie Mac: $4,147.
Item: Guarantee fees and other fee income; Fannie Mae: 1,633.4; Freddie
Mac: 1,639.
Item: Net interest income; Fannie Mae: 8,090.1; Freddie Mac: 5,480.
Item: Provision for losses; Fannie Mae: 115; Freddie Mac: (45).
Item: Estimated losses due to foreclosures; Fannie Mae: (192.7);
Freddie
Mac: (39).
Item: Administrative expenses; Fannie Mae: (1,017.6); Freddie Mac:
(844).
Source: Enterprise Investor/Analyst Reports.
[End of table]
[End of section]
Appendix III Comments from Freddie Mac:
Freddie Mac: We Open Doors:
Edward L. Golding, Senior Vice President:
Housing Economics & Financial Research:
(703) 903-23707:
Fax (703) 903-4077:
Email: edward_golding@freddiemac.com:
8200 Jones Beach Drive, Mailstop 486:
McLean, VA 22102-3310:
June 3, 2002:
Mr. Thomas J. McCool, Managing Director:
Financial Markets and Community Investment:
U.S. General Accounting Office:
Washington, D.C. 20410:
Dear Mr. McCool:
Thank you for giving us the opportunity to review GAO‘s draft report,
OFHEO‘s Risk-Based Capital Stress Test: Incorporating New Business is
Not
Advisable. We also appreciate the opportunity to meet with GAO staff
during
their preparation of the report to offer our perspective on this issue.
Freddie Mac agrees with GAO‘s conclusion that the Office of Federal
Enterprise
Housing Oversight (OFHEO) should not incorporate new business
assumptions into
its risk-based capital stress test. We agree with GAO that determining
the
assumptions is inherently speculative and that introducing them would
increase
the complexity of the stress test and reduce its transparency by making
it more
difficult to understand. In addition, we agree that supervisory review
of OFHEO
should work in conjunction with the capital standards to help ensure
Freddie
Mac‘s safety and soundness.
Please contact me if you have any questions of if we may be of further
assistance.
Sincerely,
Edward Golding, Senior Vice President:
Housing Economics and Financial Research:
Signed by Edward Golding.
[End of Section]
Related GAO Products:
Federal Home Loan Bank System: Establishment of a New Capital
Structure.
GAO-01-873. Washington, D.C.: July 20, 2001.
Comparison of Financial Institution Regulators‘ Enforcement and Prompt
Corrective Action Authorities. GAO-01-322R. Washington, D.C.: January
31, 2001.
Capital Structure of the Federal Home Loan Bank System. GAO/GGD-99-
177R. Washington, D.C.: August 31, 1999.
Farmer Mac: Revised Charter Enhances Secondary Market Activity, but
Growth Depends on Various Factors. GAO/GGD-99-85. Washington, D.C.: May
21, 1999.
Federal Housing Finance Board: Actions Needed to Improve Regulatory
Oversight. GAO/GGD-98-203. Washington, D.C.: September 18, 1998.
Federal Housing Enterprises: HUD‘s Mission Oversight Needs to Be
Strengthened. GAO/GGD-98-173. Washington, D.C.: July 28, 1998.
Risk-Based Capital: Regulatory and Industry Approaches to Capital and
Risk. GAO/GGD-98-153. Washington, D.C.: July 20, 1998.
Government-Sponsored Enterprises: Federal Oversight Needed for
Nonmortgage Investments. GAO/GGD-98-48. Washington, D.C.: March 11,
1998.
Federal Housing Enterprises: OFHEO Faces Challenges in Implementing a
Comprehensive Oversight Program. GAO/GGD-98-6. Washington, D.C.:
October 22, 1997.
Government-Sponsored Enterprises: Advantages and Disadvantages of
Creating a Single Housing GSE Regulator. GAO/GGD-97-139. Washington,
D.C.: July 9, 1997.
Housing Enterprises: Investment, Authority, Policies, and Practices.
GAO/GGD-91-137R. Washington, D.C.: June 27, 1997.
Comments on ’The Enterprise Resource Bank Act of 1996.“ GAO/GGD-96-
140R. Washington, D.C.: June 27, 1996.
Housing Enterprises: Potential Impacts of Severing Government
Sponsorship. GAO/GGD-96-120. Washington, D.C.: May 13, 1996.
Letter from James L. Bothwell, Director, Financial Institutions and
Markets Issues, GAO, to the Honorable James A. Leach, Chairman,
Committee on Banking and Financial Services, U.S. House of
Representatives, Re: GAO‘s views on the ’Federal Home Loan Bank System
Modernization Act of 1995.“ B-260498. Washington, D.C.: October 11,
1995.
FHLBank System: Reforms Needed to Promote Its Safety, Soundness, and
Effectiveness. GAO/T-GGD-95-244. Washington, D.C.: September 27, 1995.
Housing Finance: Improving the Federal Home Loan Bank System‘s
Affordable Housing Program. GAO/RCED-95-82. Washington, D.C.: June 9,
1995.
Government-Sponsored Enterprises: Development of the Federal Housing
Enterprise Financial Regulator. GAO/GGD-95-123. Washington, D.C.: May
30, 1995.
Farm Credit System: Repayment of Federal Assistance and Competitive
Position. GAO/GGD-94-39. Washington, D.C.: March 10, 1994.
Farm Credit System: Farm Credit Administration Effectively Addresses
Identified Problems. GAO/GGD-94-14. Washington, D.C.: January 7, 1994.
Federal Home Loan Bank System: Reforms Needed to Promote Its Safety,
Soundness, and Effectiveness. GAO/GGD-94-38. Washington, D.C.:
December 8, 1993.
Improved Regulatory Structure and Minimum Capital Standards are Needed
for Government-Sponsored Enterprises. GAO/T-GGD-91-41. Washington,
D.C.: June 11, 1991.
Government-Sponsored Enterprises: A Framework for Limiting the
Government‘s Exposure to Risks. GAO/GGD-91-90. Washington, D.C.: May
22, 1991.
Government-Sponsored Enterprises: The Government‘s Exposure to Risks.
GAO/GGD-90-97. Washington, D.C.: August 15, 1990.
[End of Section]
FOOTNOTES
[1] P. L. No. 102-550, title XIII (1992). The mandate is codified at 12
U.S.C. § 4611 (a)(3)(C) (2000).
[2] The level of risk-based capital a regulated institution is required
to hold is based on potential losses the institution faces as a result
of its activities.
[3] 12 C.F.R. part 1750 (2002).
[4] The Congressional Budget is also required to submit an opinion.
[5] The enterprises‘ charters restrict them to buying mortgages that do
not exceed a set dollar amount. This ceiling is known as the conforming
loan limit.
[6] For financial purposes, capital is generally defined as the long-
term funding for a firm that cushions the firm against unexpected
losses.
[7] Generally, credit risk is the risk of loss that arises when
borrowers fail to repay their loans, other parties fail to meet their
obligations to administer or guarantee loans, or both.
[8] Generally, interest rate risk is the exposure to possible losses
and
changes in value arising from changes in interest rate.
[9] Generally, management and operations risk is the exposure to
financial loss from inadequate systems, management failure, faulty
controls, or human error.
[10] Due to data limitations, we compared enterprise purchases with
total
single-family originations.
[11] An enterprise‘s total mortgage portfolio includes on-balance
mortgage
assets plus off-balance sheet MBS held by investors. MBS issuance moves
mortgage assets and associated interest-rate risk off the enterprise‘s
balance sheet unless the enterprise repurchases the securities.
[12] Callable debt refers to financial debt instruments, such as bonds,
that are redeemable by the issuer before the scheduled maturity. The
issuer
must pay the holders a premium price if such a security is retired
early.
Bonds are usually called when interest rates fall so significantly that
the issuer can save money by floating new bonds at lower rates.
[13] The act defines seasoning as ’the change over time in the ratio of
the unpaid principal balance of a mortgage to the value of the property
by which such mortgage loan is secured.“ 12 U.S.C. § 4611 (d)(1)
(2000).
[14] A single-family mortgage loan finances a one-to four-unit
residential property; multifamily loans finance properties with five or
more housing units.
[15] Part of this decline in mortgage balances is the result of factors
such as defaults.
[16] S. Rep. No. 102-282 at 22 (1992).
[17] The act gave the Secretary of HUD exclusive authority to
promulgate
numeric housing goals for the enterprises and to monitor and enforce
compliance with these goals.
[18] Fannie Mae officials distinguish between long- and short-term
models,
with long-term models covering periods of more than 4 years. Freddie
Mac
officials distinguish between capital adequacy (or risk) models and
models
used to manage day-to-day business (and for planning).
[19] The enterprises face credit risks that are similar to those faced
by
private mortgage insurance companies.
[20] Requirements for the test can be found at 12 C.F.R. part 650
(2002). We did not evaluate FCA‘s stress test.
[21] Under the act, the director of OFHEO, among other considerations,
is required to ensure that the regulations ’shall contain specific
requirements,
definitions, methods, variables and parameters used under the risk-
based capital
test and in implementing the test (such as loan loss severity, float
income,
loan-to-value ratios, taxes, yield curve slopes, default experience,
and prepayment
rates).“ 12 U.S.C. § 4611 (e)(2) (2000).
[22] The act requires OFHEO‘s risk-based capital regulations to be
’sufficiently
specific to permit an individual other than the director to apply the
test in
the same manner as (OFHEO).“ 12 U.S.C. § 4611 (e)(2) (2000).
[23] Capitalization Study of the Federal National Mortgage Association
and the
Federal Home Loan Mortgage Corporation (November 1991); 1991 Report to
Congress
on the Federal Home Loan Mortgage Corporation (December 1992); 1991
Report to
Congress on the Federal National Mortgage Association (December 1992).
[24] See U.S. General Accounting Office, Comparison of Financial
Institution Regulators‘ Enforcement and Prompt Corrective Action
Authorities, GAO-01-322R (Washington, D.C.: Jan. 31, 2001). Unlike
other depository institution regulators, OFHEO lacks the authority to
remove officers and directors, place an enterprise into receivership,
or bring suit on the agency‘s behalf (OFHEO must rely on the Attorney
General).
[25] On January 25, 2002, OFHEO published regulations on prompt
supervisory response and corrective action. The regulations contain the
procedures under which OFHEO is to take prompt corrective action in
response to specified declines in enterprise capital levels and
contains a system of prompt supervisory responses to be taken when
specified developments internal or external to an enterprise warrant
special supervisory review. 67 Fed. Reg. 3587 (Jan. 25, 2002).
[26] The act directs the Secretary to exercise this authority by
issuing
the rules and regulations necessary and proper to ensure that the
purposes
of the enterprises‘ charter acts are accomplished. 12 U.S.C. § 4541
(2000).
[27] Federal Housing Enterprises Financial Safety and Soundness Act of
1992,
P. L. No. 102-550, title XIII, 106 stat. 3672, 3941. HUD currently has
numeric
goals in place for the years 2001 through 2003. For example, the low-
and
moderate-income goal is set at 50 percent of each enterprise‘s mortgage
purchases, an increase from the 42-percent requirement set for the
years
1997 through 1999.
[28] The act contains provisions authorizing, and in some circumstances
requiring, OFHEO to take supervisory and/or enforcement actions based
on the degree to which an enterprise is undercapitalized. See 12 U.S.C.
§§ 4614-4636 (2000).
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