OFHEO's Risk-Based Capital Stress Test:
Incorporating New Business Is Not Advisable
GAO-02-521: Published: Jun 28, 2002. Publicly Released: Jun 28, 2002.
GAO 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.
Recommendation for Executive Action
Status: Closed - Implemented
Comments: The Office of Federal Housing Enterprises Oversight (OFHEO), the regulator of Fannie Mae and Freddie Mac, has chosen a course of regulatory action that is consistent with our recommendation, which was designed to ensure efficient oversight of the two large government sponsored enterprises (GSE). Based on work mandated by Congress on the substantive issue of whether to incorporate new business assumptions, we, and subsequently the Congressional Budget Office, recommended that OFHEO not incorporate new business assumptions into the stress test the agency uses to establish risk-based capital standards for the GSEs. Prior to OFHEO's establishment, the Department of Housing and Urban Development created the precedent of inclusion of new business assumptions by incorporating such assumptions into its stress test for GSEs. Considering the mandate and this precedent--although we called for no action to incorporate new business assumptions--the recommendation is substantive. OFHEO's stress test is designed to ensure that the GSEs hold capital that is commensurate with the risk they face. The stress test estimates how much capital the GSEs would be required to hold over a ten-year period to withstand potential economic shocks, such as sharp movements in interest rates. OFHEO implemented its risk-based capital rule on September 13, 2001, and the agency had the option of deciding to incorporate new business assumptions into the stress test four years after its implementation (or September 13, 2005). OFHEO currently has no plans to incorporate new business assumptions into the stress test as GAO recommended. To do so, would have required OFHEO to specify details about the types and quality of new mortgages the GSEs would acquire over the ten year stress period, the types of funding that would be required to acquire such mortgages, and other operating and financial strategies. GAO found that new business is an important determinant of the expected future financial condition of the GSEs; however, GAO also found that determining the appropriate new business assumptions to include in OFHEO's model would be difficult and inherently speculative. For instance, OFHEO would need to consider the GSE management's capacity, not only to make adjustments in the face of uncertainty, but also to make assumptions about actions the GSEs might take to improve their financial condition. 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. Therefore, rather than relying on the incorporation of new business assumptions, GAO concluded that OFHEO could use its supervisory review function to limit risk-taking by the GSEs.
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 Affected: Department of Housing and Urban Development: Office of Federal Housing Enterprise Oversight