Washington, D.C. – ​Armando Falcon, Jr., Director of the Office of Federal Housing Enterprise Oversight (OFHEO), safety and soundness regulator for Fannie Mae and Freddie Mac (the Enterprises), announced today that both Enterprises passed the first application of the risk-based capital stress test.

"The risk-based capital stress test is a success," said Director Falcon. "It is a state-of-the-art capital standard performing the function Congress intended. The risk-based capital stress test requires the Enterprises to safely manage their risks or hold additional capital commensurate with their risk exposures," said Falcon. "With the proposal of the rule in 1999, the Enterprises began a program of managing their activities to ensure they would meet the requirements of the rule. Their prudent measures combined with favorable economic conditions have resulted in their passing the standard at this stage of the one-year implementation period."

OFHEO will not use the risk-based capital standard to classify the Enterprises for regulatory purposes until the end of the third quarter 2002. These results will be released in December. Starting then, an Enterprise will need to meet both its risk-based and minimum capital requirements to be classified as adequately capitalized. Until then, it need only meet its minimum requirement. However, OFHEO makes the following information available in the interest of public disclosure and regulatory transparency:

FANNIE MAE​
As of March 31, 2002, Fannie Mae's risk-based capital requirement was $20.228 billion. Fannie Mae's total capital of $26.290 billion on that date exceeded the risk-based capital requirement by $6.062 billion. However, Fannie Mae's higher minimum capital requirement of $24.571 billion was binding.

FREDDIE MAC
As of March 31, 2002, Freddie Mac's risk-based capital requirement was $5.680 billion. Freddie Mac's total capital of $21.360 billion on that date exceeded the requirement by $15.680 billion. However, Freddie Mac's higher minimum capital requirement of $19.390 billion was binding.

ANALYSIS 

An Enterprise's risk-based requirement will vary from quarter to quarter depending on the Enterprise's risk management decisions and market conditions. Accordingly, and especially during this implementation period, it is reasonable for the Enterprises to take appropriate steps to ensure they maintain a comfortable capital cushion.

As of March 31, 2002, both Enterprises passed the stress test due to effective risk management including extensive interest rate hedging. Over the past three years since the risk-based capital rule was proposed, both Enterprises. use of derivatives increased dramatically. Fannie Mae's notional derivatives volumes rose 172 percent while Freddie Mac's volumes jumped 248 percent. The rule gives the Enterprises credit when they engage in effective risk management behavior. Freddie Mac's stress test results were especially strong because its hedges enabled it to maintain positive net interest income through nearly the full stress period in both interest rate scenarios.

The results also reflect the current relatively low-risk environment for the Enterprises. Because interest rates are low, the likelihood of very large changes is less than it would be in higher rate environments. In accordance with the statutory formula, the increase in the 10-year Treasury yield in the stress test as applied for March 31 is 371 basis points, less than the 600 basis point change applicable in higher rate environments. In the low interest rate scenario, the decrease in the 10-year Treasury yield is 247 basis points in the test, as applied for March 31.

The credit risk environment is also quite favorable. Rapidly increasing house prices in recent years have raised the value of the collateral on seasoned loans, which comprise most of the Enterprises. portfolios. Over the past three years, house prices have risen 24 percent, on average. A typical loan made in early 1998 with a loan-to-value ratio of 95 percent amounted to only 72 percent of the property value by March 2002. The risk default is, therefore, fairly low, and the severity in the event of default is also low. By comparison, house prices rose at only a 1.5 percent average annual rate in the early 1990s and seasoned loans remained subject to much higher risk.

BACKGROUND ​

The minimum capital standard requires each Enterprise to have core capital (the sum of the par value of common and preferred stock, additional paid-in capital, and retained earnings) that meets or exceeds its minimum capital requirement (2.5 percent of assets plus 0.45 percent of adjusted off-balance-sheet obligations). Minimum capital represents an essential amount of capital needed to protect an Enterprise against broad categories of business risk.

The risk-based capital standard requires each Enterprise to have total capital (core capital plus general loss reserves) that meets or exceeds its risk-based capital requirement. Stress test results are calculated for two interest rate scenarios, one in which 10-year Treasury yields rise 75 percent and another in which they fall 50 percent. Changes in both scenarios are generally capped at 600 basis points. The risk-based capital level for an Enterprise is the amount of total capital that would enable it to survive the stress test in whichever scenario is more adverse for that Enterprise, plus 30 percent of that amount to cover management and operations risk.  

The risk-based capital rule was proposed in April 1999 and finalized September 13, 2001. The rule was further amended March 15, 2002. The rule will be used for capital classification starting with data for September 30, 2002. That number will be published at the end of this year. Both Enterprises were classified as adequately capitalized on March 31, 2002, and would have achieved that same classification had the risk-based standard been used, as well.

The tables below provide relevant capital data for each Enterprise as of March 31, 2002.

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SUMMARY OF OFHEO'S RI​SK-BASED CAPITAL REGULATION FOR FANNIE MAE AND FREDDIE MAC

OFHEO's Mission

OFHEO was required by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (1992 Act) to establish minimum and risk-based capital standards as part of its role as safety and soundness regulator. These capital requirements are intended to ensure both Enterprises continue to operate and perform their crucial roles in the secondary mortgage market, keeping constant the flow of funds to mortgage lenders and prospective American homeowners. By ensuring the Enterprises are adequately capitalized, OFHEO minimizes the risk that American taxpayers will ever be asked to pay for losses at these complex financial institutions.

OFHEO evaluates capital adequacy from other perspectives as well. OFHEO's examination program conducts continuous, comprehensive examinations of the Enterprises to ensure they are operating under standards of financial safety and soundness. OFHEO's examination of the Enterprises provides a qualitative assessment of capital adequacy. The more direct and quantitative tools are OFHEO's minimum and risk-based capital standards, which are supplemented with other tests and analyses. OFHEO's minimum capital standard is calculated based on specific percentages for assets and off-balance sheet guarantees. The minimum capital level is therefore determined more by the size of the Enterprise than its specific risks. The risk-based standard, in contrast, requires that Fannie Mae and Freddie Mac each have enough capital to survive prolonged, severe problems in financial and economic markets, as well as management or operational failures. It is directly related to the risks the Enterprises are exposed to in their current business.

The Risk-Based Capital Rule

The risk-based capital regulation meets the specific requirements of the 1992 Act. The rule utilizes a stress test to determine the amount of capital needed to protect against credit and interest rate risks, and requires an additional 30 percent more capital to protect against unspecified management and operations risk. The regulation itself is the blueprint needed to construct the stress test and calculate the risk-based capital requirement for Freddie Mac and Fannie Mae. It is a detailed description of the stress test to allow the Enterprises and others to essentially replicate the stress test, as required by law.

What is the Stress Test?

OFHEO's risk-based capital standard is based on a 10-year stress test. A stress test measures risk in the context of a company's overall portfolio, including the effectiveness of a company's risk management positions. While companies often use stress tests for internal risk management, and rating agencies use stress tests to rate companies and securities, OFHEO is among the first financial institution regulators to use its own stress test to determine capital adequacy.

OFHEO’s stress test simulates an Enterprise's financial performance over a 10-year period under severe economic conditions. Key aspects of the severe economic conditions used in OFHEO’s stress test are defined in the 1992 Act and further specified in OFHEO’s risk-based capital regulation. These conditions include high levels of mortgage defaults, with associated losses and large, sustained movements in interest rates, both increasing (up-rate scenario) and decreasing (down-rate scenario).

OFHEO uses a detailed computer model to simulate each Enterprise's cash flows associated with mortgages and other financial assets and obligations under the severe economic conditions of the stress test. The modeling of incoming and outgoing cash flows captures the risks embedded in those financial assets and obligations and the benefits of the hedges each Enterprise has set in place. To meet OFHEO’s risk-based capital standard, each Enterprise must have sufficient capital to survive the losses under these severe economic conditions plus an additional 30 percent for unspecified management and operations risks. The result is a stringent test of the capital adequacy of each Enterprise.

Results of the Stress Test

*the minimum capital requirement is compared to Enterprise core capital. 

What do the Results Mean?

For the quarter ending March 31, 2002, both Fannie Mae and Freddie Mac had enough capital to survive the 10-year stress test plus 30 percent, as specified in OFHEO’s regulation. Both Enterprises would be considered “adequately capitalized” if OFHEO had used the risk-based standard to make a capital classification. In addition, for both Enterprises the minimum capital requirement was higher than the risk-based capital requirement for the first quarter.

These results only apply to the first quarter, 2002. Future quarters results will be dependent on current economic conditions, and the risks associated with each Enterprise's book of business as of the last date of that quarter.

A projected capital shortfall does not imply that an Enterprise actually has to raise that amount of capital. The risk-based capital standard captures the “bottom line” risk exposure of the Enterprises, taking into account all of their risk-taking and risk-management activities, in light of current economic conditions. Therefore, an Enterprise can meet any potential capital shortfall by reducing risk, raising capital, or a combination of the two. The regulation does not prescribe any particular approach to capital compliance.

In many cases, relatively inexpensive hedging strategies can substantially reduce required capital by reducing interest rate risk. Alternatively, an Enterprise might choose to reduce credit risk either through innovative hedging transactions (such as credit derivatives) or by increasing mortgage credit enhancements. Conversely, a projected capital surplus does not necessarily mean that an Enterprise has too much capital. Each Enterprise still must meet its minimum capital requirement, which is more a function of size than specific risks.

Benefits of the Risk-Based Capital Regulation

The stress test provides Enterprise management with incentives to carefully manage risk. OFHEO’s stress test aligns the capital requirement for each Enterprise with its specific risk profile. For example, risk reduction activities such as the effective use of interest rate derivatives, the use of private mortgage insurance (PMI) for high loan-to-value (LTV) mortgages, and the use of callable long-term debt all work to lower the risk-based capital requirement. Conversely, activities that increase risk, such as taking on unhedged interest rate exposures, serve to increase the risk-based capital requirement.

The stress test provides an early warning signal of potential future problems. The dynamic nature of a stress test facilitates OFHEO’s understanding of how changes in the economy could impact the Enterprises. It will also help OFHEO uncover changes in capital needs before there could be a significant impact on the Enterprises’ balance sheets. In contrast, capital standards based on static ratios are affected only after economic changes impact the balance sheet.

The risk-based capital standard encourages safe and sound innovations. Provisions in the regulation allow OFHEO to reflect the risk characteristics of new products and risk management techniques as soon as they are implemented by the Enterprises, applying the same risk-sensitive principles embodied in the stress test. These provisions allow OFHEO to treat innovative products and risk management techniques fairly and incorporate their impact on the Enterprises’ capital requirements on a timely basis.

OFHEO’s stress test provides the Enterprises with transparency, certainty, and flexibility in meeting their regulatory capital requirements. Both Enterprises have copies of OFHEO’s stress test and have incorporated the test into their business processes. An Enterprise can comply with OFHEO’s risk-based capital standard by reducing risk or raising capital, or a combination of both. Therefore, each Enterprise can follow its own unique strategy to comply with OFHEO’s risk-based capital standard.

OFHEO's Risk-Based Capital Standard is Vital for Effective Regulatory Oversight

The risk-based capital standard is a key measure of Enterprise financial safety and soundness. With our comprehensive examination program, it provides OFHEO with the necessary tools for effective regulatory oversight. The examination program ensures the integrity of Enterprise policies and processes in all risk management areas, and informs the qualitative evaluation presented in OFHEO’s annual report to Congress. The risk-based capital standard ensures that the quantity of risk undertaken by an Enterprise never exceeds what can be supported by its capital base. At the same time, the risk-based capital standard provides assurance that the Enterprises’ capital, as compared to other financial institutions, properly reflects the lower relative risk of most of the mortgages they guarantee.

Implications for the Housing Market

OFHEO’s risk-based capital standard will help ensure that Freddie Mac and Fannie Mae will be able to fulfill their important public purposes, both in good times and in bad times, when they will be needed most.

The risk-based capital standard contributes to OFHEO’s ability to monitor the safety and soundness of Freddie Mac and Fannie Mae. Through this mechanism, OFHEO is able to support the availability of affordable housing and protect the nation's housing markets.

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Q & A ON THE RISK-BASED CAPITAL STRESS TEST

RELATIONSHIP BETWEEN MINIMUM AND ​RISK-BASED CAPITAL REQUIREMENTS

​​Question: Does OFHEO require the Enterprises to meet more than one measure of capital adequacy?

Answer: The 1992 Act that established OFHEO specified two types of capital requirements for the Enterprises. The first, a minimum capital requirement, is a simple ratio-based calculation, which specifies a “minimum” and a “critical” level of capital. The Enterprises are required to maintain a minimum level of capital equal to the sum of 2.5% of their on-balance sheet assets plus .45% of their outstanding off-balance sheet guarantees. The critical capital levels are 1.25% and .25%, respectively. Minimum capital represents an essential amount of capital needed to protect an Enterprise against broad categories of business risk.

Question: What does risk-based capital comprise, and how did OFHEO determine the conditions in its stress test?

Answer: OFHEO’s risk-based capital requirement is the amount of total capital – core capital plus a general allowance for foreclosure losses – that an Enterprise must hold to absorb projected losses flowing from future severe interest rate and credit risk conditions, plus 30% to cover management and operations risk. In the 1992 Act, Congress specified the broad parameters of the stressful conditions underpinning the stress test that determines an Enterprise's risk-based capital requirement. The final RBC regulation published in September 2001, as amended in March 2002, fleshed out in detail these economically stressful scenarios.

Question: Now that OFHEO has a final RBC rule, do the Enterprises need to meet both a minimum and risk-based capital requirement?

Answer: Yes, however, the 1992 Act requires that until the third quarter of 2002, OFHEO’s quarterly classification of an Enterprise's capital adequacy is determined by whether the Enterprise met its minimum capital requirement. Thereafter, an Enterprise must meet both the minimum and risk-based requirements in order to be classified as adequately capitalized each quarter.

Question: What is the relationship between the minimum and risk-based capital requirements?

Answer: The minimum and risk-based capital requirements are complementary. The first sets an absolute floor, related to the level of Enterprise assets and obligations, below which capital should not dip. It ensures there is capital available to protect against risks not modeled in the OFHEO stress test. The second requirement ensures a healthy relationship between the level of risk undertaken at a particular time by an Enterprise, and the level of capital it must hold. As a far more risk-sensitive measure, the risk-based requirement is designed to expose hidden weaknesses in an Enterprise that seems financially sound under normal conditions using more traditional capital measures.

​CAPITAL CLASSIFICATION PROCESS

Question: What are the statutory requirements for classifying the adequacy of capital held by an Enterprise? What capital requirements are used to determine the capital classifications?

Answer: OFHEO is required by the 1992 Act to classify​ the adequacy of the capital held by each Enterprise based upon risk-based and minimum capital requirements. The minimum capital requirement (which includes both a “minimum” and a lower “critical” level) is a traditional ratio-based standard calculated by applying percentage factors to all on-balance-sheet assets and various specified off-balance-sheet items such as loan guarantees, loan purchase commitments, and derivatives. The risk-based capital requirement is based on the sum of two capital amounts: (1) the amount of capital an Enterprise needs to survive a ten-year period of credit and interest rate stress, as determined by OFHEO’s stress test, and an additional 30 percent of that amount to cover managem​ent and operations risk.

Question: What are the capital classifications for an Enterprise? What criteria are used to determine the capital classifications?

Answer: An Enterprise that meets or exceeds both the minimum and risk-based capital requirements will be classified as “adequately capitalized.” An Enterprise that meets the minimum capital requirements, but does not meet the risk-based capital requirements would be classified as “undercapitalized.” An Enterprise that does not meet the minimum capital requirements would be classified as “significantly undercapitalized.” An Enterprise that holds less than the critical capital requirement would be classified as “critically undercapitalized.”

Question: How frequently will the capital classification process be conducted?

Answer: In most cases, the Director will issue a regular quarterly capital classification within 90 days of a quarter's close. The Director has discretion, however, to modify the period for submission of data by the Enterprises. The Director may also make capital classifications more frequently than quarterly and may compress or extend the period that an Enterprise has to comment on the proposed classification.

Question: Will the capital classification process be public?

Answer: The capital classification process will be non-public until the Director makes a final determination. This policy serves to prevent the release of confidential information or the premature release of the proposed capital classification.

Question: How will the capital classification process be implemented during the initial year after the risk-based capital rule takes effect?

Answer: For quarters ending prior to September 13, 2002, an Enterprise's capital classification will be based solely on its minimum and critical capital requirements. An Enterprise will be classified as “adequately capitalized if it maintains an amount of core capital that is equal to or greater than the minimum capital level. Starting with the third quarter, 2002, an Enterprise's capital classification will also be based on its risk-based capital requirement. An Enterprise will be classified as .adequately capitalized. if it meets the risk-based capital requirement and maintains an amount of core capital that is equal to or greater than the minimum capital level.​

HOW RBC CONTRIBUTES TO LONG-RUN SAFETY AND SOUNDNESS ONE TOOL AMONG MANY

Question: Is OFHEO’s RBC regime different in any important respects from the existing RBC requirements for depository institutions?