Office of Federal Housing Enterprise Oversight; Risk-Based Capital

AGENCY:

Office of Federal Housing Enterprise Oversight, HUD.

ACTION:

Notice of proposed rulemaking.

SUMMARY:

The Office of Federal Housing Enterprise Oversight (OFHEO) is proposing to make technical and correcting amendments to Appendix A to Subpart B of 12 CFR Part 1750 Risk-Based Capital. The proposed amendments are intended to enhance the accuracy of the calculation of the risk-based capital requirement for the Enterprises.

DATES:

Comments regarding this Notice of Proposed Rulemaking must be received in writing on or before September 23, 2002.

FOR FURTHER INFORMATION CONTACT:

Robert Pomeranz, Senior Accounting Specialist, Office of Risk Analysis and Model Development, telephone (202) 414-3796 or Jamie Schwing, Associate General Counsel, telephone (202) 414-3787 (not toll free numbers), Office of Federal Housing Enterprise Oversight, Fourth Floor, 1700 G Street, NW., Washington, DC 20552. The telephone number for the Telecommunications Device for the Deaf is (800) 877-8339.

SUPPLEMENTARY INFORMATION:

Background

OFHEO published a final regulation setting forth a risk-based capital stress test on September 13, 2001, 12 CFR part 1750 (the Rule), which formed 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).

This document proposes to make minor technical corrections to the Rule and to update the treatment of Financial Accounting Standard 133 (FAS 133) in the Rule. These changes relate to:

(1) Capital classification, which would be updated to cross reference to the Prompt Supervisory Response and Corrective Action regulation, 12 CFR part 1777;

(2) Out-of-date third party sources of information related to interest rate indexes (e.g. 30-year CMT, Bloomberg Tickers), which would be updated to reflect currently available indexes. Specifically, the 30-year constant maturity yield is no longer reported by the Federal Reserve in the H.15 Release. In its place, the U.S. Treasury Department has developed a methodology using its “Long-Term Average Rate” and “Extrapolation Factors” designed to generate a substitute for the 30-year CMT yield series discontinued in February 2002. Similarly, the Bloomberg tickers for the Federal Agency Cost of Funds would be updated. Table 3-18 would be amended to reflect these changes;

(3) Credit Ratings in Table 3-30, which would be updated to include certain credit ratings used in the marketplace that were not listed in the original table. Specifically, Moody assigns an additional rating from VMIG1 through VMIG3 to quantify the risks of the demand feature, and Standard & Poor's rates short term issuances as SP-1+, SP-1, SP-2, and SP-3;

(4) Paragraph 3.6.3.4.3.1[a]3.a on single family default and prepayment explanatory variables, which would be replaced in full, including equations, to correct the parenthetical (q= −7, −6,...0,1,...40);

(5) Table 3-35, in which the explanatory variable categories for Relative Spread (RS_q) in the explanatory variable column were identified incorrectly;

(6) The equation related to mortgage credit enhancement procedures at paragraph 3.6.3.6.4.3, which would be corrected to reflect the fact that in extreme circumstances (i.e., when defaults are zero), an equation in section 3.6.3.6.4.3 Morgtgage Credit Enhancement Procedures produces “divide by zero” errors in the computer code;

(7) Table 3-56 and 3-57, with respect to the definition for “unamortized balance” for the RBC input for single class MBS cash flows;

(8) Table 3-59, which incorrectly reported values for the weighted average Original LTV, rather than the weighted average Amortized Original LTV (AOLTV) of the combined Enterprise portfolios by Original LTV category, as of 2Q2000. Also, the specific amounts would be removed from column 2 and column 3 of the table, because OFHEO plans to update this table annually. A footnote to the table notes that this information will be updated according to OFHEO guideline #404 and will be available on the OFHEO website;

(9) The equation in 3.7.3.1.g.2 for calculating haircuts for mortgage backed securities, which mistakenly specified an addition sign (+) rather than a multiplication sign (×) in the Federal Register version of the document;

(10) Table 3-68, which would be revised to reflect that the Table relates to long caps and floors;

(11) The calculation of common stock dividends to reflect the effects of FAS 133 adjustments on after tax income; and

(12) The calculation of the risk-based capital requirement to account for the effects of FAS 133 on Total Capital.

All of the proposed amendments address provisions of the Rule that are out-of-date, incorrect, or contain typographical errors. Most of the amendments do not materially impact the risk-based capital requirement for either Enterprise and would improve the accuracy of the calculation of the risk-based capital requirement for each Enterprise.

The change to the calculation of the risk-based capital requirement to account for the effect of FAS 133 on Total Capital will impact the risk-based capital requirement in any particular quarter, but will not consistently raise or consistently lower capital requirements for the Enterprises. If the change had been applied in the first quarter of 2002, Freddie Mac's risk-based capital requirement would have increased by approximately $1.652 billion (an amount that would have left Freddie Mac with a $14.028 billion surplus) and Fannie Mae's requirement would have increased by about $121 million (an amount that would have left Fannie Mae with a $5.941 billion surplus) if the adjustments had been made at that time. Depending upon the market value of an Enterprise's derivative portfolio, however, the proposed change could decrease, rather than increase an Enterprise's capital in a particular quarter.

The initial Rule included an adjustment that anticipated FAS 133, but at that time, the full impact of FAS 133 on the Enterprises' capital requirements was not clear. With the benefit of subsequent analysis, OFHEO now proposes to add precision to the FAS 133 adjustment, as explained below.

The stress test mandated by Congress determines for specific economic scenarios, the impact on Enterprise capital over time of the income and expenses associated with all on- and off-balance sheet positions. The stress test scenarios involve changing interest rates. FAS 133 requires that many previously off-balance sheet derivative positions be reflected on the balance sheet at their fair values. These fair values reflect the present values of gains or losses that are expected, given current interest rates, to be realized over time.

In the Rule, OFHEO indicated that, to the extent that Generally Accepted Accounting Principles (GAAP) was applicable, the risk-based capital requirement calculation should adhere to GAAP. The Rule, however, also recognized that, in certain situations, a rigid conformity to GAAP would not be possible given the stylized nature of the stress test. OFHEO, therefore, determined that with respect to FAS 133, it would be “impracticable and unreasonably speculative to make mark-to-market adjustments over the ten-year stress test.” Consistent with that determination, OFHEO stated that the stress test would not reflect derivatives at their fair market values during the stress test as required by FAS 133. Instead, these assets are adjusted to an amortized cost basis at the start of the stress test.

The stress test, therefore, reflects the effectiveness of hedges by considering their cash flows over ten years, without marking positions to market monthly over the ten years of the stress period. Thus, before applying the stress test, OFHEO backs out the effects of FAS 133 from Enterprise balance sheets, reflecting assets, liabilities and off-balance sheet items at amortized cost.

Per Section 3.10.3.6.2[a] 1.b of the Rule, the carrying value of derivative instruments and related hedged items that are designated Fair Value Hedges are reversed, increasing or decreasing retained earnings. The capital value arrived at after these adjustments (starting capital) is available at the beginning of, and is depleted during, the stress test (per Section 3.12.2). This starting capital value differs from “Total Capital” as defined in section 1750.11(n) of the regulation (and in the 1992 Act, 12 U.S.C. 4502 (18)) and, as publicly disclosed by the Enterprises. Unlike the starting capital, Total Capital does not include the starting position adjustments reversing the effects of FAS 133. The adjustments affect the amount of retained earnings throughout the stress test, a critical element in computing the risk-based capital requirement. Because the 1992 Act requires that the risk-based capital surplus or deficit must be based on Total Capital (12 U.S.C. 4611), it is appropriate to adjust the amount of capital depleted during the stress test to add back in the effects of FAS 133. For this reason, the proposed amendment adds FAS 133 starting-position adjustments that affect retained earnings (which may be positive or negative amounts) to the amount of capital consumed during the stress test. Implementation of the recommended treatment will result in a risk-based capital requirement calculated on a basis more consistent with the calculation of Total Capital.

This proposal is not expected to generate significant commentary, as all of the proposed amendments are technical in nature and address provisions of the Rule that are out-of-date, incorrect or contain typographical errors. Accordingly, OFHEO has determined that the ten-day comment period provides sufficient opportunity for public response.

Regulatory Impact

Executive Order 12866, Regulatory Planning and Review

This document contains proposed amendments to the Rule, which was designated a major rule by the Office of Management and Budget (OMB). The proposed amendments provide that Enterprise risk-based capital requirements would be more consistent with both statutory requirements and Enterprise disclosures. OFHEO has determined that the amendments to the Rule are not economically significant for purposes of Executive Order 12866. OFHEO has not found evidence that the amendments would require the Enterprises to expend more than $100 million nor that they would have a cumulative impact of that amount on the economy. The impact of the amendment is to align risk with capital more accurately, but the amendments do not consistently raise or lower capital requirements for the Enterprises. Further, the adjustments proposed herein are of a technical nature that address accounting and reporting concerns and do not involve novel policy issues. Therefore, this amendment is not a “significant rule” under Executive Order 12866.

Paperwork Reduction Act

These proposed amendments do 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 regulation under the Regulatory Flexibility Act. The General Counsel of OFHEO certifies that the proposed regulation 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—CAPITAL

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

Authority: 12 U.S.C. 4513, 4514, 4611, 4612, 4614, 4615, 4618. 2. Amend appendix A to subpart B of part 1750 as follows: a. Revise Table 3-3 in paragraph 3.1.2.1 [c]; b. Revise Table 3-18 in paragraph 3.1.3.1 [c]; c. Revise paragraph 3.3.1 [b]; d. Revise Table 3-30 in paragraph 3.5.3 [a] 2.a.; e. Revise paragraph 3.6.3.4.3.1 [a] 3.a.; f. Revise Table 3-35 in paragraph 3.6.3.4.3.2 [a] 1.; g. In paragraph 3.6.3.6.3.3 [a] 1., remove the term “GL_m” both places it appears and replace it with “GLS_m”. h. In paragraph 3.6.3.6.4.3 [a] 5., after the words “Defaulted UPB:” and before the equation, by adding the following equation:

Image Not Available

i. In paragraph 3.7.2.1.1., Table 3-56, in the row entitled “Unamortized Balance”, remove the three sentences in the Description column and replace them with the following four sentences: “The sum of all unamortized discounts, premiums, fees, commissions, etc. If proceeds from debt or amount paid for an asset total greater than par, report the premium as a positive number. If proceeds from debt or amount paid for an asset total less than par, report the discount as a negative number. Report all fees as a negative number.”

j. In paragraph 3.7.2.1.2 [a], Table 3-57, in the row entitled “Unamortized Balance”, remove the three sentences in the Description column and replace them with the following four sentences: “The sum of all unamortized discounts, premiums, fees, commissions, etc.

If proceeds from debt or amount paid for an asset total greater than par, report the premium as a positive number. If proceeds from debt or amount paid for an asset total less than par, report the discount as a negative number. Report all fees as a negative number.”

k. Revise Table 3-59 in paragraph 3.7.2.3;

l. Revise paragraph 3.7.3.1 [g] 2.;

m. Revise Table 3-68 in paragraph 3.8.3.6.1 [e] 2.;

n. Revise paragraph 3.10.3.2 [a] 2.;

o. In paragraph 3.11.2 [a], remove the cross reference “1750.2(c)” and replace it with the cross reference “1750.12(c)”;

p. Revise paragraph 3.11.3 [c];

q. In paragraph 3.12.2 [a], add the words “outputs and selected inputs from” after the words “Alternative Modeling Treatments, and”; and

r. Add new paragraph 3.12.3 [a] 9. after paragraph 3.12.3 [a] 8.

The revisions and additions read as follows:

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

3.1.2.1. * * *

[c] * * *

3.1.3.1 * * *

[c] * * *

3.3.1 * * *

[b] The process for determining interest rates is as follows: first, identify the 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-, and 20-year CMTs; fourth, estimate the 30-year CMT; fifth, project non-treasury Interest Rates, including the Federal Agency Cost of Funds Index; and sixth, 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. Guidance in determining interest rates is available under OFHEO Guideline No. 402, “Risk Based Capital Process for Capturing and Utilizing Interest Rates Files,” which is available on OFHEO's web site, http://www.OFHEO.Gov .

3.5.3 * * *

[a] * * *

2. * * *

a. * * *

3.6.3.4.3.1 * * *

[a] * * *

3. * * *

a. Compare mortgage rates for each quarter of the Stress Test and for the eight quarters prior to the start of the stress test (q = −7, −6,...0, 1,...40):

Image Not Available

Note:

For this purpose, MCONm is required for the 24 months (eight quarters) prior to the start of the Stress Test. Also, MIRm = MIR0 for m < 0.

3.6.3.4.3.2. * * *

[a] * * *

1. * * *

3.7.2.3 * * *

3.7.3.1 * * *

[g] * * *

2. Compute:

Image Not Available

3.8.3.6.1 * * *

[e] * * *

3.10.3.2. * * *

[a] * * *

2. Common Stock. In the first year of the Stress Test, dividends are paid on common stock in each of the four quarters after preferred dividends, if any, are paid unless the Enterprise's capital is, or after the payment, would be, below the estimated minimum capital requirement.

a. First Quarter. In the first quarter, the dividend is the dividend per share ratio for common stock from the quarter preceding the Stress Test times the current number of shares of common stock outstanding.

b. Subsequent Quarters.

(1) In the three subsequent quarters, if the preceding quarter's after tax income is greater than after tax income in the quarter preceding the Stress Test (adjusted by the ratio of Enterprise retained earnings and retained earnings after adjustments are made that revert investment securities and derivatives to amortized cost), pay the larger of (1) the dividend per share ratio for common stock from the quarter preceding the Stress Test times the current number of shares of common stock outstanding or (2) the average dividend payout ratio for common stock for the four quarters preceding the start of the Stress Test times the preceding quarter's after tax income (adjusted by the reciprocal of the ratio of Enterprise retained earnings and retained earnings after adjustments are made that revert investment securities and derivatives to amortized cost) less preferred dividends paid in the current quarter. In no case may the dividend payment exceed an amount equal to core capital less the estimated minimum capital requirement at the end of the preceding quarter.

(2) If the previous quarter's after tax income is less than or equal to after tax income in the quarter preceding the Stress Test (adjusted by the ratio of Enterprise retained earnings and retained earnings after adjustments are made that revert investment securities and derivatives to amortized cost), pay the lesser of (1) the dividend per share ratio for common stock for the quarter preceding the Stress Test times the current number of shares of common stock outstanding or (2) an amount equal to core capital less the estimated minimum capital requirement at the end of the preceding quarter, but not less than zero.

3.11.3 * * *

[c] OFHEO will provide the Enterprise with its estimate of the capital treatment as soon as possible after receiving notice of the New Activity. In any event, the Enterprise will be notified of the capital treatment in accordance with the notice of proposed capital classification provided for in § 1777.21 of this chapter.

3.12.3 * * *

[a] * * *

9. Subtract the net increase (or add the net decrease) in Retained Earnings related to Fair Value Hedges at the start of the stress test made in accordance with section 3.10.3.6.2 [a] 1. b. of this appendix.