[Federal Register Volume 61, Number 131 (Monday, July 8, 1996)]
[Rules and Regulations]
[Pages 35607-35623]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-17120]
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DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT
12 CFR Part 1750
RIN 2550-AA03
Office of Federal Housing Enterprise Oversight; Minimum Capital
AGENCY: Office of Federal Housing Enterprise Oversight, HUD.
ACTION: Final regulation.
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SUMMARY: The Office of Federal Housing Enterprise Oversight (OFHEO) is
issuing a final regulation that sets forth the methodology for
computing the minimum capital requirement for the Federal National
Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation (Freddie Mac) (collectively, the Enterprises). The final
regulation also establishes procedures for the filing of quarterly
minimum capital reports by each Enterprise. In addition, the final
regulation establishes procedures under which OFHEO will determine the
capital classification of each Enterprise on a quarterly basis.
EFFECTIVE DATE: August 7, 1996.
FOR FURTHER INFORMATION CONTACT: Gary L. Norton, Deputy General Counsel
(202/414-3800); Isabella W. Sammons, Associate General Counsel (202/
414-3800); Michael P. Scott, Assistant Director, Office of Research,
Analysis and Capital Standards (202/414-3800), 1700 G Street, N.W., 4th
Floor, Washington, D.C. 20552.
SUPPLEMENTARY INFORMATION:
I. Background
Title XIII of the Housing and Community Development Act of 1992,
Pub. L. No. 102-550, known as the Federal Housing Enterprises Financial
Safety and Soundness Act of 1992 (1992 Act), established OFHEO as an
independent office within the Department of Housing and Urban
Development. OFHEO is responsible for ensuring that the Enterprises are
adequately capitalized and operating in a safe and sound manner.
Included among the express statutory authorities of the Director of
OFHEO is the authority to issue regulations establishing minimum and
risk-based capital standards.1
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\1\ 1992 Act, section 1313(b)(1) (12 U.S.C. 4513(b)(1)).
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As a separate rulemaking procedure, OFHEO published an Advance
Notice of Proposed Rulemaking (ANPR) 2 as the first step toward
developing the risk-based capital regulation required by section 1361
of the 1992 Act.3 The risk-based capital regulation will specify a
stress test that will determine the amount of capital that an
Enterprise must hold to maintain positive capital throughout a 10-year
period of economic stress. That amount, plus an additional 30 percent
to cover management and operations risk, will constitute the risk-based
capital requirement of the Enterprise.
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\2\ 60 FR 7468, Feb. 8, 1995.
\3\ 12 U.S.C. 4611.
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The ANPR solicited public comment on a variety of issues concerning
the development of the risk-based capital regulation. In light of the
complex issues, OFHEO decided to issue the proposed risk-based capital
regulation in two Notices of Proposed Rulemaking (NPRs).
The first NPR addresses two key components of the stress test--the
``benchmark loss experience'' (the basis for determining the extent of
Enterprise credit losses during the stress test) and the use of the
OFHEO House Price Index (HPI) in the stress test to estimate changes
over time in the values of single-family properties securing Enterprise
mortgages.4 A second NPR, currently being developed, will address
the remaining aspects of the risk-based capital stress test and how the
stress test will be used to determine the Enterprises' risk-based
capital requirements.
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\4\ 61 FR 29592, Jun. 11, 1996.
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In addition to the risk-based capital standard, the 1992 Act
prescribes a minimum capital standard for the Enterprises.5 This
final regulation implements the minimum capital standard of the 1992
Act. Unlike the risk-based capital requirement that is computed by
applying the stress test, the minimum capital requirement is computed
on the basis of capital ratios that are applied to certain defined on-
balance sheet assets and off-balance sheet obligations of the
Enterprises.
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\5\ Section 1362 (12 U.S.C. 4612).
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OFHEO issued a proposed Minimum Capital regulation on June 8,
1995.6 As discussed in the preamble to the proposed regulation,
the proposed regulation contained the interim administrative procedures
with respect to the methodology for computing the minimum capital
requirement for on- and off-balance sheet items, except for interest
rate and foreign exchange rate contracts for which the methodology was
modified. The proposed regulation also established procedures for the
filing of minimum capital reports by the Enterprises each quarter, or
at other times as required by the Director. The proposed regulation
further required OFHEO to provide each Enterprise with notice and
opportunity to comment on its proposed capital classification.
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\6\ 60 FR 30201.
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OFHEO received five comments in response to the proposed
regulation. Comments were received from a federal government agency
(Office of Thrift Supervision), both Enterprises, and two trade
associations (America's Community Bankers and Mortgage Bankers
Association of America). OFHEO has carefully considered the comments in
developing the final regulation. A discussion of the comments received
follows.
II. Comments on the Proposed Minimum Capital Regulation
General Comments
Freddie Mac commented generally on OFHEO's role with respect to the
[[Page 35608]]
minimum capital standard of the 1992 Act. First, Freddie Mac noted that
the 1992 Act details what the capital standard is, unlike the statutes
governing the capital standards for banks and thrifts. Therefore,
Freddie Mac concluded that the Minimum Capital regulation should
reflect Congress' intent that OFHEO act as the implementor, rather than
the creator, of the minimum capital standard.
OFHEO agrees that its role is to implement the minimum capital
standard set forth in the 1992 Act. Nevertheless, Congress specifically
authorized OFHEO to adjust the capital ratios that are applied to
certain off-balance sheet obligations, the credit risk of which differs
from that of mortgage-backed securities (MBS). Additionally, in
implementing the 1992 Act, OFHEO must define those terms not defined
therein. OFHEO believes that the final regulation effectively
implements the minimum capital standard in a manner completely
consistent with the specific provisions and overall intent of the 1992
Act.
Secondly, Freddie Mac stated that Congress recognized that the
minimum capital standard would create marginal capital requirements and
that marginal capital requirements tend to induce changes in the
Enterprises' behavior.7 Therefore, Freddie Mac explained, Congress
cautioned OFHEO against creating ``perverse incentives'' that may
induce Freddie Mac to make inappropriate changes in the conduct of its
businesses.8 Freddie Mac further noted that, in the context of
OFHEO's risk-based capital standard, ``OFHEO has expressed a policy of
designing the [risk-based] capital regulation to reflect closely the
relative risks inherent in the Enterprises' different activities,
rather than setting out to encourage or discourage particular
activities by means of a [risk-based] capital regulation that rewards
or punishes an Enterprise that engages in such activities.' Freddie Mac
urged OFHEO to apply this policy to its design of the Minimum Capital
regulation.
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\7\ Marginal capital requirements are incremental capital
requirements for each additional dollar of business.
\8\ Freddie Mac cites S. Rep. No. 282, 102d Cong., 2d Sess. 24
(1992).
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As recognized by Freddie Mac, congressional concern regarding the
creation of perverse incentives was expressed in the context of the
discussion of risk-based capital and the appropriate level of detail of
the stress test.9 OFHEO has stated that, where feasible, it will
endeavor to avoid the creation of perverse incentives in its risk-based
capital regulation for the Enterprises. However, this concept has
little relevance to the minimum capital standard. The minimum capital
requirement is computed on the basis of simple leverage ratios.
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\9\ The Senate report accompanying the legislation states: ``A
more detailed [stress test] model will be more likely to create the
right incentives and less likely to create perverse incentives.'' S.
Rep. No. 282, 102d Cong., 2d Sess. 24 (1992).
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The proposed regulation deviates from the specific statutory ratios
in only one area--by adjusting the statutory ratio of 0.45 percent for
certain off-balance sheet obligations relative to the credit risk of
MBS. The proposed regulation establishes different minimum capital
ratios for collateralized and uncollateralized exposure for interest
rate and foreign exchange rate contracts. Although OFHEO considered
using a single capital ratio applied to all interest rate and foreign
exchange rate contracts, thus treating contracts as one broad risk
category, OFHEO believes that making a distinction between
collateralized and uncollateralized exposure provides the Enterprises
with better risk management incentives.
Section 1750.1 General
Section 1750.1 of the proposed Minimum Capital regulation provides
in part that:
The board of directors of each Enterprise is responsible for
ensuring that the Enterprise maintains capital at a level that is
sufficient to ensure the continued financial viability of the
Enterprise and in excess of the minimum capital level contained in
this Subpart A.
Freddie Mac recommended that the phrase ``is sufficient to ensure
the continued financial viability of the Enterprise'' be deleted from
section 1750.1 because it appears to establish a new or additional
capital standard not provided for in the 1992 Act. Freddie Mac stated
that, in light of the comprehensive guidance in the 1992 Act as to how
to determine the levels of capital that the Enterprises are required to
hold, it would be inappropriate for OFHEO, by regulation, to amend the
minimum capital standard of the 1992 Act by adding a financial
viability standard.
OFHEO disagrees with Freddie Mac's view because OFHEO has the duty
and authority to ensure the safe and sound financial operation of the
Enterprises, and none of the capital levels specified in the 1992 Act
represent the amount needed by an Enterprise to operate safely and
soundly under all circumstances. The language in proposed section
1750.1 is consistent with OFHEO's authority under section 1313(a) of
the 1992 Act,10 which provides that the duty of the Director is to
ensure that the Enterprises are adequately capitalized and operating
safely. OFHEO's specific authority to issue the Minimum Capital
regulation is derived from section 1313(b) of the 1992 Act,11
which provides the Director with the authority to issue regulations to
carry out (a) part 1 of subtitle A of the 1992 Act (which establishes
OFHEO and sets forth OFHEO's authorities), (b) subtitle B (which sets
forth the required capital levels for the Enterprises and OFHEO's
special enforcement powers with respect to capital levels), (c)
subtitle C (which sets forth OFHEO's enforcement provisions), and (d)
``other matters relating to safety and soundness.'' As explained in
section 1302 of the 1992 Act,12 Congress finds that--
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\10\ 12 U.S.C. 4513(a).
\11\ 12 U.S.C. 4513(b).
\12\ 12 U.S.C. 4501.
* * * an entity regulating such enterprises should have the
authority to establish capital standards, require financial
disclosure, prescribe adequate standards for books and records and
other internal controls, conduct examinations when necessary, and
enforce compliance with the standards and rules that it establishes
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* * *.
Section 1750.1 is also consistent with the manner in which the
capitalization provisions of the 1992 Act are designed to operate. The
capitalization provisions in the 1992 Act are structured in the
following way. The 1992 Act provides for both ``mandatory'' and
``discretionary'' capital classifications.13 The 1992 Act also
sets forth certain supervisory actions that are specific to each
capital classification.14
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\13\ Section 1364 (12 U.S.C. 4614).
\14\ Sections 1365-1367 (12 U.S.C. 4615-4617).
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Under the discretionary capital classification criteria, the
Director may reclassify an Enterprise at a lower capital level than it
would be classified under the mandatory classification criteria. The
Director may do so if the Enterprise is engaging in conduct that could
result in a rapid depletion of core capital or the value of the
property subject to mortgages held or securitized by the Enterprise has
decreased significantly.15
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\15\ Section 1364(b) (12 U.S.C. 4614(b)).
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When the Enterprise is placed in a lower capital classification as
a result of either a mandatory or discretionary classification, it is
required to increase its capital pursuant to a mandatory capital
restoration plan.16 The Director's discretionary classification
authority thus could have the effect of requiring
[[Page 35609]]
an Enterprise that is engaging in certain types of risky activities to
increase the amount of capital it holds, pursuant to a mandatory
capital restoration plan, even though it meets or exceeds the minimum
capital or risk-based capital requirement.17
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\16\ Sections 1365(a)(1) and 1369C (12 U.S.C. 4615(a)(1) and
4622).
\17\ Section 1365 (12 U.S.C. 4615).
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The discretionary classification authority reflects the statutory
scheme that the minimum capital ratios in the 1992 Act establishes a
``floor'' on capital, not a ``ceiling.'' The legislative history of the
1992 Act indicates that there was some confusion regarding this issue
that was resolved in favor of the ``floor'' approach. For example,
during Senate consideration of the bill, Senator Metzenbaum stated to
the Chairman of the Committee:
[You] said on this floor that the Director [of OFHEO] did indeed
have the authority to set the required ratios above the minimum
levels * * * if necessary to protect the health and security of an
enterprise and that it is important that the Director act in those
circumstances. Since that time, I have learned that some Senators
may have a different view about the Director's authority. I would
like to be assured by the chairman of the committee and the manager
of this bill that the director has authority to raise capital
standards, if necessary.
Senator Riegle, in replying, explained that:
[T]he Director is given the duty to ensure that the enterprises
are adequately capitalized and operating safely in accordance with
this act and the Charter Acts. Under section 103(a)(1) of the bill,
the Director is authorized to issue regulations concerning the
financial health and security of the enterprises, including the
establishment of capital standards. There is no way the Director can
discharge these responsibilities unless he or she has the authority
to prescribe capital standards to be met by the enterprises.
* * * * *
Unless the legislation specifically and affirmatively prohibits
the Director from establishing required capital ratios, it must be
assumed that the Director has that authority in order to discharge
his or her duties assigned under section 102 * * *. The only
constraint on the Director's authority is that the required capital
ratios cannot be set below the minimum levels contained in section
202.
* * * * *
If the Director believed that the minimum statutory ratios * * *
should be raised, he or she would obviously have to seek a change in
the law. A Director might believe an increase in the statutory
minimum ratios * * * to be necessary if he or she concluded that
they were clearly inadequate under all foreseeable circumstances. If
the Congress were to so raise the statutory minimum ratios * * * it
would establish a new and higher floor applicable to the Director's
discretionary authority to prescribe capital ratios. However, there
is nothing in the legislation that would preclude the Director from
setting the required rated * * * without further legislation. If the
circumstances that gave rise to the need for higher ratios changed,
the Director could then reduce the required capital ratios, but not
lower than the minimum ratios * * *.18
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\18\ 138 Cong. Rec. S9353-54 (July 1, 1992). This colloquy was
with respect to section 202, Minimum Capital Levels, of S. 2733.
Although the 1992 Act was a compromise between S. 2733 and H.R.
2900, section 202 of S. 2733 is substantially similar to section
1362 of the 1992 Act. Therefore, the colloquy with respect to
section 202, cited above, is relevant to the discussion of section
1362 of the 1992 Act.
In the House of Representatives, the issue of whether the minimum
capital ratios constituted a floor or a ceiling was raised during the
consideration of the conference report. In a discussion between the
Chairman and Ranking Member of the Committee, the two members agreed
that the duty of the Director to ensure that the Enterprises are
adequately capitalized and operating safely in accordance with the 1992
Act authorizes the Director to require a higher ratio than the minimum
ratio specified in the statute.19
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\19\ 138 Cong. Rec. H11,102 (Oct. 3, 1992) (discussion by Mr.
Gonzalez, Mr. Frank, and Mr. Leach). In response to Mr. Gonzalez'
explanation, Mr. Leach stated that ``I fully share with you the
interpretation that would imply that the Director could go above the
2.5-percent requirement that is currently in statute [sic] * * *.''
Id.
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Freddie Mac further questioned why the board of directors of each
Enterprise is held responsible for maintaining capital at a level that
is sufficient to ensure the continued viability of the Enterprise.
Freddie Mac stated that the board of directors has a fiduciary duty to
protect the interests of the Enterprise's shareholders, and that
maintaining an adequate level of capital under varying circumstances
would be one aspect of the overall set of responsibilities represented
within that duty. Furthermore, Freddie Mac stated that the fiduciary
duties of corporate directors are derived principally from state common
law, so the adoption of a viability standard and corresponding
responsibility could interfere with the subtleties and complexities of
that law.
OFHEO believes that to the extent there is any conflict between
state law and the 1992 Act, the conflict would be resolved in favor of
the 1992 Act and implementing regulations. The Enterprises are
federally-chartered entities subject to federal statutory and
regulatory requirements. The 1992 Act imposes capital requirements on
the Enterprises and makes clear that the board of directors of each
Enterprise is responsible for the financial safety and soundness of the
Enterprise. Specifically, the Director is authorized to take
enforcement actions, e.g., cease and desist orders and civil money
penalties, against directors of an Enterprise for actions that deplete
the core capital of the Enterprise, cause a loss to the Enterprise, or
violate an order or regulation of OFHEO.20 In exercising its
enforcement powers, OFHEO will be cognizant of all of the relevant
federal and, if applicable, state requirements. However, to the extent
there are any applicable state law requirements relating to the
fiduciary responsibilities of the directors, they would not override
the obligations created by the 1992 Act or the Minimum Capital
regulation.
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\20\ See sections 1371, 1372, and 1376 (12 U.S.C. 4631, 4632,
and 4636).
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Freddie Mac also recommended that the phrase ``in excess of the
minimum capital level'' be replaced by ``is equal to or exceeds the
minimum capital level'' in order to reflect accurately the minimum
capital standard set forth in the 1992 Act. OFHEO agrees and has
revised section 1750.1 accordingly. OFHEO has also substituted, where
appropriate, the word ``requirement'' for ``level'' to ensure
consistency of terms throughout the Minimum Capital regulation.
Section 1750.1 of the proposed regulation also contains a sentence
that reads: ``The regulation contained in this Subpart A establishes
the minimum capital requirements for each Enterprise.'' Freddie Mac
recommended an editorial change that would clarify that the regulation
sets forth the ``methodology'' for computing the minimum capital
requirement for each Enterprise. OFHEO agrees with the need for this
change and the final regulation has been revised accordingly.
Section 1750.2 Definitions
Proposed Section 1750.2 defines various terms used in the Minimum
Capital regulation. OFHEO received comments on the definitions of the
following terms: commitment, core capital, foreign exchange rate
contract, interest rate contract, multifamily credit enhancement, off-
balance sheet obligation, other off-balance sheet obligations, and
qualifying collateral. The comments are discussed below.
Commitment
Freddie Mac recommended that, for the purpose of the minimum
capital requirement computation, the term ``commitment'' should be
defined as a legally binding agreement that obligates an Enterprise to
purchase mortgages that
[[Page 35610]]
specify all the terms of the transaction, including price, volume, and
fees.
Freddie Mac referenced its comments to OFHEO's ANPR on risk-based
capital.21 In those comments, Freddie Mac stated that, as a matter
of general contract law, an agreement is legally binding only if all of
its key terms are included and agreed upon. Therefore, any definition
of a contractual commitment should include a requirement that it be a
binding contractual obligation of the Enterprise to purchase mortgages
and specify price, volume, and fees.
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\21\ ``Comments of the Federal Home Loan Mortgage Corporation on
the Advance Notice of Proposed Rulemaking on Risk-Based Capital of
the Office of Federal Housing Enterprise Oversight,'' 139-146 (May
9, 1995) (available at OFHEO).
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OFHEO agrees that for purposes of the Minimum Capital regulation
the term ``commitment'' should mean any legally binding agreement that
obligates an Enterprise to purchase or securitize mortgages, and has
defined the term as such. However, OFHEO does not believe it necessary
or appropriate to restrict the definition of the term ``commitment'' by
reference to price, volume, and fees because agreements may be legally
binding even when there is a lack of specificity on all terms.22
It would not be possible for OFHEO to reflect the complexities of this
area of contract law in a regulatory definition. Moreover, to do so
would be inadvisable in light of Congress' specific concerns regarding
the need for capital to support commitments and other off-balance sheet
obligations.
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\22\ See Restatement (Second) of Contracts section 204 (1981).
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For example, in discussing the need for the capital requirements of
the 1992 Act, Congress expressed the concern that off-balance sheet
obligations had not been previously captured under prior capital
standards:
The capital provisions of the GSEs' charter Acts limit their
debt to 15 times their capital unless HUD sets a higher ratio * * *
This is unsatisfactory because no capital need be held against the
GSEs' $750 billion of off balance sheet guarantees * * *. 23
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\23\ S. Rep. No. 282, 102d Cong., 2d Sess. 11 (1992).
Recognizing this concern, it would be inappropriate for OFHEO to
promulgate a narrow definition that could exempt certain legally
binding commitments from the minimum capital calculation.
OFHEO has made editorial revisions to the definition of the term
``commitment'' by substituting the word ``agreement'' for
``arrangement'' and by deleting the phrase ``for portfolio.''
Core Capital
In drafting the definition of core capital in the proposed
regulation, OFHEO made minor changes to the statutory language that
were intended to improve the clarity of the provision. Freddie Mac
commented that since Congress expressly defined core capital in section
1303(4) of the 1992 Act,24 the regulation should use the same
statutory language to avoid confusion. In light of the comment
received, OFHEO wants to ensure that the regulation does not create any
confusion and has revised the definition of core capital in the final
regulation to mirror the statutory definition.
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\24\ 12 U.S.C. 4502(4).
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Foreign Exchange Rate Contracts and Interest Rate Contracts
OFHEO received a comment from Freddie Mac on the definitions of the
terms ``foreign exchange rate contracts'' and ``interest rate
contracts.'' Freddie Mac stated that the definitions of these terms as
they appear in section 1750.2 and Appendix A of the proposed regulation
are not identical. To avoid any implication that the differences are
intentional, Freddie Mac recommended that OFHEO define the terms only
in one location, or that OFHEO conform the language of the two sets of
definitions.
The different ways these terms are used in the regulation and
Appendix A make it is necessary to include a definition in the main
body of the regulation as well as a separate discussion in Appendix A.
However, in light of the comment, OFHEO has made editorial changes to
conform the definitions of the terms ``foreign exchange rate
contracts'' and ``interest rate contracts'' in section 1750.2 to the
discussion of such terms in Appendix A.
Multifamily Credit Enhancement
Section 1750.2 of the proposed regulation defines the term
multifamily credit enhancement to mean ``a guarantee by an Enterprise
of the payments on a multifamily mortgage revenue bond issued by a
state or local housing finance agency.''
Fannie Mae recommended that OFHEO revise the definition to describe
more fully the routine types of transactions in which an Enterprise
engages ``to support multifamily bond issues.'' Fannie Mae stated that
it normally provides credit enhancement through a collateral pledge,
purchase agreement, or other contractual obligation by which the
mortgage loan risk is borne by the Enterprise during a period in which
the bonds are credit enhanced by a letter of credit or surety
obligation of another party.
Fannie Mae also commented that under many state laws, other state
and local governmental units or instrumentalities may issue mortgage
revenue bonds, not only state and local housing finance agencies.
Therefore, Fannie Mae recommended that the definition should be
expanded to include any state and local governmental issuers authorized
to issue such revenue bonds secured by mortgages.
OFHEO agrees with the comment and has revised the definition of the
term ``multifamily credit enhancement'' to describe more fully the
routine types of transactions in which an Enterprise engages to support
multifamily bond issues.
Off-balance Sheet Obligation and Other Off-Balance Sheet Obligations
OFHEO received comments from Freddie Mac on the definitions of the
terms ``off-balance sheet obligation'' and ``other off-balance sheet
obligations.'' The term ``off-balance sheet obligation'' is defined in
proposed section 1750.2 to mean--
* * * a binding agreement, contract, or similar arrangement that
requires or may require future payment(s) in money or kind by
another party to an Enterprise or that effectively guarantees all or
part of such payment(s) to third parties, where such agreement or
contract is a source of credit risk that is not included on its
balance sheet.
The term ``other off-balance sheet obligations'' is defined in proposed
section 1750.2 to mean--
* * * all off-balance sheet obligations of an Enterprise that are
not mortgage-backed securities or substantially equivalent
instruments.
Freddie Mac noted that section 1362(a)(3) of the 1992 Act 25
requires the Enterprises to hold 0.45 percent core capital against
other off-balance sheet obligations (excluding commitments in excess of
50 percent of the average dollar amount of commitments outstanding each
quarter over the preceding four quarters), except as the Director
adjusts the 0.45 percent ratio to reflect differences between the
credit risk of such obligations and MBS. Freddie Mac stated that an
obligation of an Enterprise does not subject the Enterprise directly to
credit risk: ``it is the party holding the obligation that bears the
credit risk of an Enterprise obligation.'' However, while the
obligations of an Enterprise create no
[[Page 35611]]
direct credit risk for the Enterprise, certain obligations, such as MBS
or commitments to purchase mortgages, involve identifiable credit risk
that is related in one way or another to those obligations (the risk of
the default on the associated mortgages). Freddie Mac believes that
this related credit risk is what Congress intended to capture when it
enacted the minimum capital requirement applicable to other off-balance
sheet obligations. Therefore, Freddie Mac believes that a definition of
``other off-balance sheet obligations'' will not capture the related
credit risk that is apparently the focus of the 1992 Act.
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\25\ 12 U.S.C. 4612(a)(3).
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To resolve this concern, Freddie Mac recommended that OFHEO delete
the definition of the term ``off-balance sheet obligation'' and take a
targeted approach in the definition of the term ``other off-balance
sheet obligations'' by identifying only those items that OFHEO intends
to include within the scope of the term, i.e., commitments, multifamily
credit enhancements, sold portfolio remittances pending, and interest
rate and foreign exchange rate contracts. Freddie Mac believes that
because OFHEO has considered no other items to be other off-balance
sheet obligations, such a definition would fully implement section
1362(a)(3) of the 1992 Act.26 Freddie Mac stated that, to the
extent that the Director determines in the future that other items
should be considered to be other off-balance sheet obligations, the
Director should address such items in a future rulemaking proceeding to
amend the Minimum Capital regulation. In connection with this
recommendation, Freddie Mac also recommended that section 1750.4(a)(7)
be deleted. That section provides for other off-balance sheet
obligations to be included in the computation of the minimum capital
requirement.
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\26\ Id.
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After considering Freddie Mac's comments, OFHEO has determined not
to adopt the recommendations with respect to the definition of the
terms ``off-balance sheet obligation'' and ``other off-balance sheet
obligations.'' The capital provisions of the 1992 Act require the
Enterprises to hold sufficient capital to ensure against risks of both
on- and off-balance sheet items. For off-balance sheet obligations, the
1992 Act specifies the ratio of 0.45 percent of the unpaid principal
balance of MBS and substantially equivalent instruments issued or
guaranteed by the Enterprise. The Act also specifies a ratio of 0.45
percent of other off-balance sheet obligations (excluding commitments
in excess of 50 percent of the average dollar amount of the commitments
outstanding each quarter over the preceding four quarters), except that
the Director must adjust the 0.45 percent ratio to reflect differences
between the credit risk of such obligations and MBS.
OFHEO believes that it is appropriate to provide for a definition
of other off-balance sheet obligations, which ensures that capital will
be held against all off-balance sheet obligations whether or not they
are now used by the Enterprises or at any time in the future. The 1992
Act requires that OFHEO apply a ratio of 0.45 percent to other off-
balance sheet obligations until OFHEO determines whether an adjustment
is necessary. OFHEO has determined the appropriate ratios for
commitments, multifamily credit enhancements, sold portfolio
remittances pending, interest rate contracts, and foreign exchange rate
contracts. When an Enterprise begins to use a new type of obligation,
OFHEO will apply the statutory ratio of 0.45 percent. OFHEO will then
analyze the obligation to determine whether an adjustment to the 0.45
percent ratio is necessary, and will amend the Minimum Capital
regulation, as appropriate.
Freddie Mac believes that the proposed definitions could create
confusion because they appear to conflict with how the term
``obligation'' is used elsewhere in the 1992 Act and in the
Enterprises' Charter Acts. The proposed regulation defines the term
``off-balance sheet obligation'' as a binding agreement or contract
that requires another party to make future payments in money or in kind
to an Enterprise (or guarantees of such payments to a third party). In
contrast, Freddie Mac stated that the term ``obligation'' used
elsewhere in the 1992 Act and the Enterprises' Charter Acts applies
only to future payments from an Enterprise to a third party--and not to
future payments from another party to the Enterprise (or guarantees of
such payments to a third party).
Freddie Mac also stated that the proposed definition of the term
``other off-balance sheet obligations'' could create confusion as to
whether resecuritizations of MBS, such as real estate mortgage
investment conduits and other multi-class MBS, are included in that
definition. Freddie Mac believes that it was the intent of Congress
that such resecuritizations should not be included and that OFHEO's
interim procedures do not include resecuritizations. Also, Freddie Mac
believes that the definition of the term ``other off-balance sheet
obligations'' is too narrow because commitments, which Congress
expressly considered to be other off-balance sheet obligations, would
not fall within the proposed definition of that term.
OFHEO believes that because the term ``obligation'' may be used
differently in the 1992 Act and the Enterprises' Charter Acts, it more
important to include a definition of the terms ``off-balance sheet
obligation'' and ``other off-balance sheet obligations'' for purposes
of the computation of the minimum capital requirement. However, to
eliminate any confusion regarding the treatment of commitments, the
definition of the term ``off-balance sheet obligation'' has been
revised to include an express reference to commitments. Also, the
definition of the term ``other off-balance sheet obligations'' has been
revised to clarify that resecuritizations of MBS are not included in
the definition.
Qualifying Collateral
Freddie Mac noted that the definition of the term ``qualifying
collateral'' in section 1750.2 differs from the discussion of what
constitutes qualifying collateral in paragraph 5 of Appendix A.
Consistent with this comment, OFHEO has made conforming editorial
changes to both the definition in section 1750.2 and the discussion in
Appendix A.
OFHEO has also revised the footnote in connection with the
definition of the term ``qualifying collateral'' by defining the term
``OECD-based group of counties'' to conform with the Joint Final Rule
published by the Federal Reserve System, the Office of the Comptroller
of the Currency, and the Federal Deposit Insurance Corporation.27
This final rule was promulgated after the publication of the proposed
Minimum Capital regulation.
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\27\ 60 FR 66042, Dec. 20, 1995.
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Section 1750.4 Minimum Capital Requirement Computation
Section 1750.4(a) of the proposed regulation provides that the
minimum capital requirement for each Enterprise is the sum of the
following amounts--
--2.50 percent times the aggregate on-balance sheet assets of the
Enterprise;
--0.45 percent times the unpaid principal balance of mortgage-backed
securities and substantially equivalent instruments that were issued or
guaranteed by the Enterprise;
--0.45 percent of 50 percent of the average dollar amount of
commitments outstanding each quarter over the preceding four quarters;
[[Page 35612]]
--0.45 percent of the outstanding principal amount of bonds with
multifamily credit enhancements;
--0.45 percent of the dollar amount of sold portfolio remittances
pending;
--3.00 percent of the credit equivalent amount of interest rate and
foreign exchange rate contracts except to the extent of the current
market value of posted qualifying collateral;
--1.50 percent of the credit equivalent amount of interest rate and
foreign exchange rate contracts equal to the market value of posted
qualifying collateral; and
--0.45 percent of the outstanding amount of other off-balance sheet
obligations, excluding commitments, multifamily credit enhancements,
sold portfolio remittances pending, and interest rate and foreign
exchange rate contracts, except as adjusted by the Director to reflect
differences in the credit risk of such obligations in relation to MBS.
Section 1750.4(b) provides that any asset or financial obligation
that can be properly classified in more than one of the enumerated
categories shall be classified in the category that yields the highest
minimum capital amount.
OFHEO received comments with respect to section 1750.4, as
explained below.
Section 1750.4(a)(6) Ratios With Respect to Interest Rate and Foreign
Exchange Rate Contracts
Notice of Adjustment
Freddie Mac asserted that OFHEO has not provided adequate notice to
the Enterprises of the basis, in quantifiable terms, for the proposed
upward adjustment it makes to the 0.45 percent ratio with respect to
interest rate and foreign exchange rate contracts.
OFHEO believes that it provided adequate notice of the basis of the
proposed adjustment in the preamble of the proposed Minimum Capital
regulation. The preamble explained how OFHEO analyzed the relative
credit risk of interest rate and foreign exchange rate contracts as
compared with the credit risk of MBS. However, in light of this
comment, OFHEO believes it appropriate to summarize its reasons for
adjusting the 0.45 percent ratio.
The source of credit risk of MBS to the Enterprises is the risk of
defaults and losses on the mortgages underlying the MBS. The aggregate
credit risk associated with the underlying mortgages is low because the
Enterprises require very broad geographic diversification; strict and
consistent mortgage underwriting standards; minimum initial
collateralization of 125 percent (i.e., maximum 80 percent loan-to-
value ratio) or supplemental mortgage insurance; and increasing levels
of collateralization as loans amortize and property values increase.
Moreover, the credit risk of MBS is offset by the continuing source of
income provided by guarantee fees.
Neither Enterprise has experienced a net credit loss on its MBS.
Annual losses to date have ranged from two basis points to ten basis
points (expressed as a percentage of the outstanding portfolio), and
have been easily covered by guarantee fee income, which has ranged from
20 to 25 basis points.
The source of credit risk of interest rate and foreign exchange
rate contracts is the risk of counterparty default. The credit risk of
interest rate and foreign exchange rate contracts is greater than that
of MBS, even though the Enterprises attempt to limit the credit risk of
the contracts by restricting their business to high quality
counterparties and adjusting collateral requirements on the basis of
the counterparty credit quality and the current replacement cost of the
contracts. The credit risk associated with interest rate and foreign
exchange rate contracts is a result of the following characteristics:
Large swings in market rates, on which interest rate and
foreign exchange rate contracts are based, may simultaneously increase
exposure to and risk of default by one or more counterparties, which
are typically financial firms.
While losses may be infrequent, the high level of
interdependence of the world's major financial institutions, many of
which are important interest rate and foreign exchange rate contract
counterparties, could cause disproportionately high losses when they do
occur. This phenomenon is often referred to as ``systemic risk.''
Counterparty risk is concentrated. The loss resulting from
the default of a single counterparty could be many times larger than
the amount of capital that would be associated with the application of
a 0.45 percent capital ratio.
Interest rate and foreign exchange rate contract exposures
are not as fully collateralized as are the mortgages underlying the
Enterprises' MBS.
The interest rate and foreign exchange rate contracts
markets are comparatively new; therefore, the functioning of these
markets is less predictable in terms of operational and legal risk.
There is no current stream of fee income to offset losses
on interest rate and foreign exchange rate contracts associated with
counterparty failures.
OFHEO recognizes that, although the credit risk characteristics of
interest rate and foreign exchange rate contracts can be identified,
they are difficult to quantify. However, the 1992 Act does not require
such quantification. Rather, it requires a reasonable analysis, based
on available information, of the credit risk of interest rate and
foreign exchange rate contracts relative to that of MBS.
The fact that the Enterprises have not experienced a net credit
loss on their MBS does not mean that there are no risks associated with
these instruments. Similarly, the fact that the Enterprises have not
experienced losses associated with interest rate and foreign exchange
rate contracts does not mean that there are no risks associated with
these contracts. In these circumstances, it is appropriate for OFHEO to
analyze the relative risks of these instruments by comparing their
respective credit risk characteristics. Based on an analysis of these
relative credit risk characteristics, OFHEO adjusted the 0.45 percent
ratio applicable to MBS upward to reflect the greater risk of interest
rate and foreign exchange rate contracts. As OFHEO and the Enterprises
accumulate data on the risk of, and gain experience with the
application of the ratios for, interest rate and foreign exchange rate
contracts, OFHEO may make adjustments to the ratios, as appropriate.
Freddie Mac also commented on the upward adjustment of ratios for
interest rate and foreign exchange rate contracts in light of OFHEO's
statement in the Annual Report to Congress that the credit risk of the
Enterprises' derivatives (interest rate and foreign exchange rate)
contracts ``is very small relative to the credit risk the Enterprises
face with regard to mortgages they hold or guarantee.'' 28 This
statement was in the context of the notional values of the contracts.
As the Annual Report to Congress notes two sentences later, the
replacement cost (current credit exposure) of the contracts is
relatively small. In other words, the replacement cost, which together
with an amount for potential future credit exposure constitutes the
credit equivalent amount, is very small in comparison with the notional
amount. We note that the credit equivalent amount represents the
overall credit risk of interest rate and foreign exchange rate
contracts.
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\28\ OFHEO, Annual Report to Congress, 9 (June 15, 1995).
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Lowering the Proposed Ratios
Fannie Mae recommended lowering the proposed ratios from 3.0
percent of
[[Page 35613]]
the credit equivalent amount of uncollateralized interest rate and
foreign exchange rate contracts and 1.5 percent of the credit
equivalent amount of collateralized contracts to 2.0 percent and 0.5
percent respectively. Fannie Mae believes that the proposed ratios are
unreasonably high in relation to the historical loss experience for
similar obligations.
Fannie Mae stated that the factors that determine an adequate
amount of required capital for interest rate and foreign exchange rate
contracts include the probability of default and the severity of
possible loss. To determine the probability of default of
collateralized interest rate and foreign exchange rate contracts,
Fannie Mae analyzed historical default statistics from Moody's
Investors Service over the past 25 years for unsecured, 5- to 9-year
term senior debt of corporations with debt ratings from Aaa to Baa.
Fannie Mae stated that it uses historical data for unsecured senior
debt because data on interest rate and foreign exchange rate contracts
is limited due to the relative newness of the market in such contracts.
Fannie Mae believes that their default rates are functionally
equivalent because interest rate and foreign exchange rate contracts
and unsecured senior debt represent general corporate obligations.
Fannie Mae stated that the average rating of its interest rate and
foreign exchange rate counterparties is Aa or A. Using the Moody's
Investors Service historical data, the default rates for unsecured
senior debt in those categories ranges from 0.3 percent to 1.5 percent.
Thus, Fannie Mae suggested that an appropriate estimate of default
incidence for its interest rate and foreign exchange rate contracts is
between 0.3 and 1.5 percent.
Fannie Mae then stated that the historical data demonstrates that
the average loss severity from 1974 through 1994 is 51.1 percent for
all corporate unsecured senior debt, and 28.4 percent for Baa or better
corporate unsecured senior debt. Multiplying the default incidence by
the loss severity yields a ``capital ratio.'' Thus, according to Fannie
Mae, a default incidence in the range of 0.3 to 1.5 percent and a
severity level in the range of 28.4 to 51.1 percent produces a
``capital ratio'' for uncollateralized interest rate and foreign
exchange rate contracts in the range of 0.1 to 0.75 percent. The ratio
that Fannie Mae recommended--2.0 percent for uncollateralized interest
rate and foreign exchange rate contracts--is 2\2/3\ times its estimated
``worst case'' ratio of 0.75 percent. Consequently, Fannie Mae believes
the recommended ratio to be an adequate and suitable minimum capital
ratio for uncollateralized interest rate and foreign exchange rate
contracts.
Fannie Mae further believes that the use of collateral
significantly reduces the severity of loss associated with interest
rate and foreign exchange rate contracts. Fannie Mae asserted that 10
percent is a reasonable estimate of expected loss severity for
collateralized interest rate and foreign exchange rate contracts,
because Fannie Mae evaluates the market value of collateral and
exposures at least monthly, Fannie Mae requires over-collateralization
if credit quality deteriorates below a specific level, and the loss
severity of uncollateralized exposures is best represented by the 28.4
percent historical loss severity experience for unsecured senior debt.
By multiplying the 10 percent loss severity by the 0.3 to 1.5 percent
historical average default rates, Fannie Mae estimated a ``capital
ratio range'' of 0.03 percent to 0.15 percent. Thus, Fannie Mae's
recommendation of a 0.5 percent ratio for collateralized interest rate
and foreign exchange rate contracts is 3\1/3\ times its estimated
``worst case.''
After carefully considering Fannie Mae's arguments, OFHEO has
decided not to reduce the proposed ratio for interest rate and foreign
exchange rate contracts. Fannie Mae's analysis assumes that the default
rate for interest rate and foreign exchange rate contracts will conform
with the historical default rates for corporate unsecured senior debt.
As Fannie Mae noted, interest rate and foreign exchange rate contracts
are relatively new instruments and historical default rates are
lacking. Therefore, OFHEO cannot assume that the default rates of
unsecured senior debt and interest rate and foreign exchange rate
contracts will prove to be comparable.
Even assuming the default rates would be comparable, Fannie Mae's
proposal does not provide an adequate capital cushion. Fannie Mae
derives what it calls ``capital ratios'' based on more than twenty
years' experience of a national sample of corporate credits. These
``capital ratios'' are in fact average national loss rates for a period
not marked by extreme economic stress. For minimum capital purposes,
Fannie Mae proposes to apply rates to both uncollateralized and
collateralized counterparty exposure that are roughly three times as
high as these capital ratios. The 1992 Act requires that any adjustment
to the 0.45 percent ratio reflect the credit risk relative to MBS.
Fannie Mae's proposed multiples are not consistent with this
requirement. As the above discussion notes, neither Enterprise has
experienced any net credit loss on its MBS. However, ignoring guarantee
fee income, annual losses to date have ranged from two basis points to
ten basis points. Thus the 0.45 percent statutory capital ratio for MBS
ranges from 4.5 to 22.5 times the historical loss experience for MBS--
higher than the 2\2/3\ and 3\1/3\ times the estimated ``worst case''
loss proposed by Fannie Mae.
Fannie Mae's analysis also ignores a number of factors which
increase the potential loss associated with the credit exposure of
interest rate and foreign exchange rate contracts that are not present
with MBS. The credit exposures of interest rate and foreign exchange
rate contracts are highly concentrated, large swings of interest rates
may simultaneously increase both the credit exposure and the default
risk, and systemic problems could cause disproportionately high losses
when they do occur.
Furthermore, Fannie Mae predicates its proposal on its current risk
management practices, with respect to counterparty creditworthiness and
collateral requirements and their enforcement. OFHEO believes that a
minimum capital requirement establishes an essential amount of capital
that an Enterprise with given levels of business must hold to address
broad categories of risk, not specific exposures. Accordingly, it
should not attempt to reflect the quality of current risk management
practices. For example, Fannie Mae's analysis assumes that it will
continue to manage credit risk by doing business with counterparties
with Aa and A ratings and that such counterparties are not subject to
sudden declines in ratings. Fannie Mae also assumes that, if ratings
decline, it will require and be able to obtain more collateral.
Even if these assumptions were valid, OFHEO believes that they
cannot be the basis of a minimum capital requirement. The minimum
capital requirement is not intended to be a risk-based capital
requirement. The 1992 Act separately provides for a risk-based capital
requirement in which credit, interest, and operational and management
risk are calculated using a stress test. The 1992 Act requires that the
0.45 percent ratio for other off-balance sheet obligations be adjusted
to reflect differences in the credit risk of the obligation and MBS.
OFHEO believes that the adjustment should be for differences in risk
associated with the inherent risk characteristics of different
instruments, not the risk characteristics of counterparties to these
obligations or
[[Page 35614]]
current risk management practices for these obligations.
Right to Raise the Ratio
America's Community Bankers recommended that OFHEO explicitly
reserve the right to raise the ratio for uncollateralized interest rate
and foreign exchange rate contracts to 4.0 percent depending on the
specific counterparty risks involved. As discussed above, OFHEO
believes that counterparty credit ratings are not the appropriate focus
of minimum capital ratios and that it has required an adequate amount
of capital for uncollateralized interest rate and foreign exchange rate
contracts. If OFHEO's experience with the application of the ratio for
interest rate and foreign exchange rate contracts proves otherwise,
OFHEO will raise the ratio. In addition, as discussed in connection
with the comments on section 1750.1, if the business practices of an
Enterprise were to endanger the capital adequacy of the Enterprise,
OFHEO would take any actions necessary to ensure the financial safety
and soundness of the Enterprise's operations.
Avoid Changing the Capital Calculation
Mortgage Bankers Association of America (MBA) stated that the
proposed change from the interim guidelines in the calculation of the
capital ratio for interest rate and foreign exchange rate contracts
does not appear to be so significant as to cause the Enterprises to
increase current guarantee fees, which would ultimately harm consumers
in the form of higher interest rates or fees. MBA understands that the
Enterprises currently have sufficient capital to meet the higher
capital ratios that would result from the proposal. Nevertheless, MBA
urged OFHEO to remain cautious and avoid changing the capital
calculation of interest rate and foreign exchange rate contracts if the
calculation influences the Enterprises' selection of funding and
hedging instruments in a way that affects their ability to manage
risks, is detrimental to their housing mission, or increases the cost
of credit to consumers.
MBA recognizes that OFHEO does not wish to jeopardize the
Enterprises' ability to meet their housing mission and goals, but must
ensure the safety and soundness of the Enterprises. MBA believes that
OFHEO should strive to strike a balance and avoid imposing inefficient
capital requirements that inhibit the management of risk.
OFHEO agrees that the capital requirements should ensure the safety
and soundness of the Enterprises while not jeopardizing the
Enterprises' ability to meet their housing mission and goals.
Consistent with that approach, OFHEO does not believe that the change
in the calculation of the capital ratio for interest rate and foreign
exchange rate contracts will adversely affect the Enterprises' ability
to manage risk or increase the cost of mortgage credit to consumers.
Furthermore, mindful of the need to strike a balance among competing
interests, OFHEO believes that it is in the best long-term interests of
consumers and the Enterprises that the Enterprises have an adequate
cushion of minimum capital to ensure against loss. While a decrease in
capital requirements could result in a reduction in mortgage credit
costs for consumers in the short-term, the decrease would not be
beneficial in the long-term if it jeopardized the financial viability
of the Enterprises.
This view is consistent with the congressional findings set forth
in the 1992 Act that recognize the Enterprises' important housing
mission and the need to provide long-term safeguards in the form of
capital requirements to reduce the risk of failure.\29\ The
congressional findings also recognize the Enterprises' obligation to
facilitate the financing of affordable housing while maintaining a
strong financial condition and a reasonable economic return.\30\
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\29\ See section 1302 (12 U.S.C. 4501).
\30\ Section 1302(7) (12 U.S.C. 4501(7)).
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``Pro Rata'' Capital Charge
The Office of Thrift Supervision asked whether the proposed
regulation would provide a reduced ``pro rata'' capital charge for
partially collateralized interest rate and foreign exchange rate
contracts. In response to this comment, OFHEO notes that section
1750.4(a)(6) provides a ratio of 3.00 percent of the credit equivalent
amount of interest rate and foreign exchange rate contracts, except to
the extent of the current market value of posted qualifying collateral;
and 1.50 percent of the market value of qualifying collateral posted to
secure interest rate and foreign exchange rate contracts, not to exceed
the credit equivalent amount of such contracts. Thus, an interest rate
or foreign exchange rate contract partially collateralized with
qualifying collateral will have a reduced capital charge to the extent
of the qualifying collateral.
Enterprises' Right to Require Collateral
Fannie Mae and Freddie Mac both stated that the market widely
perceives an agreement with a Aaa rated counterparty that agrees to
post collateral if it is downgraded to be as safe as, or safer than, a
comparable agreement with a lesser-rated counterparty that posts
collateral. They claimed that the proposed regulation would run counter
to well-established market practices by rewarding an Enterprise with a
lower capital requirement if its Aaa rated counterparties are
downgraded and post collateral under their collateral agreements, or if
the Enterprise avoids Aaa rated counterparties in favor of lesser-rated
counterparties.
Freddie Mac recommended the following standard: The same minimum
capital ratio would apply for collateralized agreements and for
uncollateralized agreements where the counterparty holds the highest
credit rating of any entity effectively recognized by the Division of
Market Regulation of the Securities and Exchange Commission as a
nationally recognized statistical rating organization for the purposes
of capital rules for broker-dealers, and has entered into a binding
agreement to post qualifying collateral if and when the counterparty no
longer holds the highest rating of such an entity. As an alternative,
Freddie Mac recommended treating the contract as fully collateralized
for purposes of computing the minimum capital requirement where a Aaa
rated counterparty has agreed to post collateral when it is downgraded.
OFHEO has considered Fannie Mae's and Freddie Mac's
recommendations, but has decided not to adopt them. The Enterprises'
recommendations rely heavily on the credit ratings of counterparties
and current Enterprise practice. In fact, Freddie Mac has noted
elsewhere that credit enhancements in which the counterparty is
required to post collateral only when its credit rating or capital
begins to deteriorate ``present some management-and-operations risk
because the arrangements need to be monitored and the collateral needs
to be posted in a timely fashion.'' \31\
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\31\ ``Comments of the Federal Home Loan Mortgage Corporation on
the Advance Notice of Proposed Rulemaking on Risk-Based Capital of
the Office of Federal Housing Enterprise Oversight,'' 72 (May 9,
1995)(available at OFHEO).
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OFHEO believes that reliance on the credit ratings of
counterparties and current Enterprise practice should not be the basis
for establishing minimum capital ratios. Even though the 1992 Act
requires that credit risk be taken into account when adjusting the
ratio for certain off-balance sheet obligations, the minimum capital
requirement essentially is computed on the basis of simple leverage
ratios. Categories of obligations that are assigned a specific ratio
include obligations with a mixture
[[Page 35615]]
of greater and lesser risk, depending on borrower or counterparty
characteristics.
Consistent with the concepts underlying ``minimum'' as opposed to
``risk-based'' capital, when developing the proposed regulation, OFHEO
considered whether the minimum capital ratio should be the same for
interest rate and foreign exchange rate contracts regardless of whether
collateral was posted. In adopting the proposed regulation, OFHEO
determined that a lower minimum capital ratio for the collateralized
portion of an obligation was appropriate. This determination was made
based on the recognition that a collateralized position affords the
Enterprises greater certainty of collection than an uncollateralized
position in the event of a decline in the financial condition of a
counterparty. In contrast, the value of a promise by a counterparty to
post collateral in the event that it is downgraded is subject to the
diminished capacity of a counterparty during times of financial stress
to identify and pledge adequate liquid assets to secure its contractual
obligations.
OFHEO also recognizes that the value of a promise by a counterparty
to post collateral when it is downgraded is influenced by the speed of
the rating agency's ability to recognize changes in credit conditions.
Recent incidents, such as the default of Barings from trading losses,
illustrate how rapidly the financial health of a well-respected entity
can deteriorate. When a decline occurs very rapidly, a promise to post
collateral to secure counterparty obligations may be of little value.
Finally, as a point of comparison, OFHEO notes that the risk-based
capital standards for banks and thrifts do not treat agreements to post
collateral as the equivalent of collateral and do not incorporate
counterparty credit ratings into the determination of risk weights
assigned to different counterparties.
Section 1750.4(a)(7) Ratio With Respect to Other Off-Balance Sheet
Obligations
Section 1750.4(a)(7) of the proposed regulation provides the amount
of other off-balance sheet obligations that is to be included in the
computation of the minimum capital requirement. The amount is--
0.45 percent of the outstanding amount of other off-balance sheet
obligations, excluding commitments, multifamily credit enhancements,
sold portfolio remittances pending, and interest rate contracts and
foreign exchange rate contracts except as adjusted by the Director to
reflect differences in the credit risk of such obligations in relation
to mortgage-backed securities.
Freddie Mac recommended that proposed section 1750.4(a)(7) be
deleted in connection with its comments that (1) the definition of the
term ``off-balance sheet obligation'' be deleted and (2) the definition
of the term ``other off-balance sheet obligations'' be defined in terms
of commitments, multifamily credit enhancements, sold portfolio
remittances pending, and interest rate and foreign exchange rate
contracts. (See the full discussion under section 1750.2, above.) If
section 1750.4(a)(7) is retained, Freddie Mac recommended that OFHEO
delete the phrase ``the outstanding amount.'' Freddie Mac believes that
the phrase could create confusion if, in the future, OFHEO determines
that an item should be treated as an ``other off-balance sheet
obligation,'' and OFHEO also determines that the appropriate measure of
credit risk should be something other than an ``outstanding amount.''
OFHEO agrees with Freddie Mac; however, rather than deleting the
phrase ``outstanding amount,'' OFHEO has substituted the phrase
``credit equivalent amount, or other appropriate measure, as determined
by the Director.'' This revision will clarify that, depending on the
specific characteristics of the obligation, the computation of the
minimum capital requirement may be based on the credit equivalent
amount or other measures that the Director determines are appropriate.
OFHEO also has made a clarifying editorial revision to proposed
section 1750.4(a)(6)(ii) with respect to the computation of the minimum
capital amount for interest rate and exchange rate contracts.
Section 1750.4(b) Capital Treatment of On-Balance Sheet and Off-
Balance Sheet Items
Section 1750.4(b) of the proposed regulation provides that, for
purposes of the minimum capital requirement computation, any asset or
financial obligation that is properly classifiable in more than one
category of items must be classified in the category that yields the
highest requirement.
Freddie Mac expressed the concern that the proposed regulation
would require capital charges for foreign exchange rate contracts to be
computed as if such contracts were reflected on the balance sheet, even
if they are not. Freddie Mac also recommended that OFHEO clarify that
the regulation will not require an Enterprise to make adjustments to a
balance sheet that has been prepared in accordance with generally
accepted accounting principles (GAAP).
As noted by Freddie Mac, the Enterprises are required to prepare
their balance sheets in accordance with GAAP. Consistent with that
requirement, the Minimum Capital regulation does not require an
Enterprise to adjust its balance sheet prepared in accordance with
GAAP. The requirements of the Minimum Capital regulation relate only to
the computation of the minimum capital requirement.
Under GAAP, it is possible that some assets or obligations may
properly be reflected either on or off the balance sheet. OFHEO
believes that, for minimum capital purposes, it is appropriate to
classify any asset or obligation that may be properly reflected either
on or off the balance sheet in the category that yields the highest
minimum capital requirement. The purpose of capital is to serve as a
cushion to absorb losses and thereby reduce the risk of failure of the
Enterprise. The minimum capital requirement represents a level of
capital for an Enterprise which, if not met, will result in the
institution being classified as 'significantly undercapitalized.''
Consequently, it would be inappropriate for the Minimum Capital
regulation to permit an Enterprise to determine its minimum capital
requirement by favoring one accounting treatment over another. The
purpose of section 1750.4(b) is to avoid such a circumstance.
In addition, Freddie Mac commented on the relationship between
section 1750.4(b) and paragraph 4 of Appendix A, suggesting that they
articulated inconsistent requirements with respect to interest rate and
foreign exchange rate contracts. In that regard, Freddie Mac
recommended that OFHEO treat all foreign exchange rate contracts as
other off-balance sheet obligations, and then subtract from the
computed minimum capital requirement the amount, if any, that is
attributable to the contracts as on-balance sheet assets.
OFHEO does not believe there is any inconsistency between section
1750.4(b) and paragraph 4 of Appendix A. The scope of the two
provisions is different and, to the extent they deal with the same
issue, they address different aspects of the issue. As explained above,
section 1750.4(b) provides that an Enterprise's assets or obligations
that may be properly classified in more than one of the on- or off-
balance sheet categories will be classified according to the category
that yields the highest
[[Page 35616]]
minimum capital requirement. The scope of section 1750.4(b) encompasses
not only interest rate and foreign exchange rate contracts, but also
any other assets or obligations that could be classified in more than
one category.
In contrast, paragraph 4 of Appendix A, Avoidance of Double
Counting, is restricted in scope to interest rate and foreign exchange
rate contracts and only addresses the issue of double counting. The
purpose of paragraph 4 is to ensure that the capital amount for such
contracts is not double counted if the proper accounting treatment
results in a portion of the credit exposure of the contract(s) being
reflected on and off the balance sheet. To that end, paragraph 4
provides that the amount of credit exposure arising from interest rate
and foreign exchange rate contracts may need to be excluded from on-
balance sheet assets in calculating the minimum capital requirement.
Section 1750.5 Notice of Capital Classification
Section 1750.5 outlines the procedures that OFHEO will follow when
notifying each Enterprise of its capital classification.
Freddie Mac noted that while the proposed regulation sets forth a
process that could result in a final capital classification not being
issued until a full 150 days after the end of a quarter, it hopes that
a process of less than 90 days would continue to be the norm.
Section 1750.3 provides that an Enterprise has 30 days after the
end of each quarter to file a minimum capital report. Section 1750.5
provides that within 60 days of receiving the minimum capital report,
OFHEO will provide each Enterprise with a notice of proposed capital
classification. The Enterprise has 30 days in which to respond to the
proposed capital classification. The Enterprise's response period may
be extended up to 30 additional calendar days, or shortened, at the
sole discretion of the Director. The Director, after taking into
consideration the Enterprise's response, has up to 30 calendar days
following the end of the response period in which to issue a final
notice of capital classification.
The time periods specified in the regulation are designed to
establish the longest possible timeframes for actions by the
Enterprises and OFHEO in the capital classification process. OFHEO
would expect that under most circumstances the total elapsed time for a
capital classification will be substantially less than the maximum
period contemplated in the regulation. In that regard, the timing of
the submission of the Enterprise's minimum capital report and its
response to the proposed classification will have a significant impact
on the time period for receipt of the final capital classification.
Appendix A
Appendix A provides the methodology for computing the minimum
capital component for interest rate and foreign exchange rate
contracts.
The Office of Thrift Supervision questioned whether OFHEO had
considered whether the proposed treatment of interest rate and foreign
exchange rate contracts, including the bilateral netting provisions,
adds unnecessary complexity to the minimum capital standard in light of
the sophisticated risk-based capital regulation that OFHEO is
developing.
Although the minimum capital standard is a minimum leverage ratio
standard, Congress has required that OFHEO consider the credit risk of
off-balance sheet obligations and adjust the 0.45 percent ratio to
reflect the difference between the credit risk of interest rate and
foreign exchange rate contracts and MBS. Thus, OFHEO believes that the
adjusted ratios should be applied to the credit equivalent amount of
interest rate and foreign exchange rate contracts because the credit
equivalent amount best represents the dollar amount at risk. OFHEO also
believes that bilateral netting, that is, the offsetting of positive
and negative mark-to-market values in the determination of a current
credit exposure used in the calculation of a credit equivalent amount,
provides a more accurate representation of the dollar amount at risk.
Consequently, OFHEO believes that the more complex treatment with
respect to interest rate and foreign exchange rate contracts is
appropriate.
Paragraph 5. Collateral
Freddie Mac noted that the definition of the term ``qualifying
collateral'' in section 1750.2 differs from the discussion of what
constitutes qualifying collateral in paragraph 5 of Appendix A. OFHEO
does not intend that there be any difference and has revised the
discussion in Appendix A to conform with the definition set forth in
section 1750.2. (See the full discussion of this comment under section
1750.2, Qualifying collateral, above.)
Additionally, OFHEO has renumbered paragraphs 1 and 2 of Appendix A
of the proposed regulation to ensure ease of reading and reference.
IV. Section-by-Section Analysis
Section 1750.1 General
This section states that the regulation sets forth the methodology
for computing the minimum capital requirement for each Enterprise. It
further states that the board of directors of each Enterprise is
responsible for ensuring that the Enterprise maintains capital at a
level that is sufficient to ensure the continued financial viability of
the Enterprise and that equals or exceeds the minimum capital
requirement.
Section 1750.2 Definitions
Section 1750.2 provides definitions for the terms used in the
regulation.
The term ``affiliate'' is defined as to mean any entity that
controls, is controlled by, or is under common control with, an
Enterprise, except as otherwise provided by the Director.
The term ``commitment'' is defined to mean any contractual, legally
binding agreement that obligates an Enterprise to purchase or to
securitize mortgages.
The term ``core capital'' is defined to mean the sum of (as
determined in accordance with generally accepted accounting principles)
the par or stated value of outstanding common stock; the par or stated
value of outstanding perpetual, noncumulative preferred stock; paid-in
capital; and retained earnings. This definition does not include debt
instruments or any amounts an Enterprise could be required to pay at
the option of an investor to retire capital instruments. The amount of
retained earnings includable in the calculation of core capital is the
net of the carrying value of Treasury stock. Treasury stock is stock
that an Enterprise has issued and subsequently acquired, but has not
retired or resold. Carrying value is typically the amount the
Enterprise paid for the Treasury stock.
The term ``Director'' is defined to mean the Director of OFHEO.
The term ``Enterprise'' is defined to mean the Federal National
Mortgage Association and any affiliate thereof or the Federal Home Loan
Mortgage Corporation and any affiliate thereof.
The term ``foreign exchange rate contracts'' is defined to mean
cross-currency interest rate swaps, forward foreign exchange contracts,
currency options purchased (including currency options purchased over-
the-counter), and any other instrument that gives rise to similar
credit risks. The definition clarifies that the term ``foreign exchange
rate contracts'' does not mean foreign exchange rate contracts with an
original maturity of 14 calendar days or less and
[[Page 35617]]
foreign exchange rate contracts traded on exchanges that require daily
payment of variation margins.
The term ``interest rate contracts'' is defined to mean single
currency interest rate swaps, basis swaps, forward rate agreements,
interest rate options purchased (including caps, collars, and floors
purchased), over-the-counter options purchased, and any other
instrument that gives rise to similar credit risks (including when-
issued securities and forward deposits accepted). The definition of the
term ``interest rate contracts'' does not include instruments traded on
exchanges that require daily payment of variation margins.
The term ``mortgage-backed security'' is defined to mean a
security, investment, or substantially equivalent instrument that
represents an interest in a pool of loans secured by mortgages or deeds
of trust where the principal or interest payments to the investor in
the security or substantially equivalent instrument are guaranteed or
effectively guaranteed by an Enterprise.
The term ``multifamily credit enhancement'' is defined to mean any
guarantee, pledge, purchase arrangement, or other obligation or
commitment provided or entered into by an Enterprise with respect to
multifamily mortgages to provide credit enhancement, liquidity,
interest rate support, and other guarantees and enhancements for
revenue bonds issued by a state or local governmental unit (including a
housing finance agency) or other bond issuer.
The term ``1992 Act'' is defined to mean the Federal Housing
Enterprises Financial Safety and Soundness Act of 1992, found at Title
XIII of the Housing and Community Development Act of 1992, Pub. L. No.
102-550.
The term ``notional amount'' is defined to mean the face value of
the underlying financial instrument(s) on which an interest rate or
foreign exchange rate contract is based.
The term ``off-balance sheet obligation'' is defined to mean a
binding agreement, contract, or similar arrangement that requires or
may require future payment(s) in money or kind by another party to an
Enterprise, or that effectively guarantees all or part of such
payment(s) to third parties (including commitments), where such
agreement or contract is a source of credit risk that is not included
on its balance sheet.
The term ``OFHEO'' is defined to mean the Office of Federal Housing
Enterprise Oversight.
The term ``other off-balance sheet obligations'' is defined to mean
all off-balance sheet obligations of an Enterprise that are not
mortgage-backed securities or substantially equivalent instruments and
that are not resecuritized MBS such as real estate mortgage investment
conduits or similar resecuritized instruments.
The term ``perpetual, noncumulative preferred stock'' is defined to
mean preferred stock that does not have a maturity date, provides the
issuer the ability and the legal right to eliminate dividends and does
not permit the accruing or payment of impaired dividends, and that
cannot be redeemed at the option of the holder. It is further defined
as preferred stock that has no other provisions that will require
future redemption of the issue, in whole or in part, or that will reset
the dividend periodically based, in whole or in part, on the
Enterprise's current credit standing, such as auction rate, money
market, or remarketable preferred stock, or that may cause the dividend
to increase to a level that could create an incentive for the issuer to
redeem the instrument, such as exploding rate stock. For purposes of
minimum capital, perpetual, noncumulative preferred stock must provide
capital that is available to absorb losses of the Enterprise from any
source.
The term ``qualifying collateral'' is defined to mean cash on
deposit; securities issued or guaranteed by the central governments of
the OECD-based group of countries,32 United States Government
agencies, or United States Government-sponsored agencies; and
securities issued by multilateral lending institutions or regional
development banks.
---------------------------------------------------------------------------
\32\ The OECD-based group of countries comprises full members of
the Organization for Economic Cooperation and Development (OECD)
regardless of entry date, as well as countries that have concluded
special lending arrangements with the International Monetary Fund
(IMF) associated with the IMF's General Arrangements to Borrow, but
excludes any country that has rescheduled its external sovereign
debt within the previous 5 years. A rescheduling of external
sovereign debt generally would include any renegotiation of terms
arising from a country's mobility or unwillingness to meet its
external debt service obligations, but generally not include any
renegotiation to allow the borrower to take advantage of a decline
in interest rate or other change in market conditions.
As of November 1995, the OECD countries included the following
countries: Australia, Austria, Belgium, Canada, Denmark, Finland,
France, Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg,
Mexico, the Netherlands, New Zealand, Norway, Portugal, Spain,
Sweden, Switzerland, Turkey, the United Kingdom, and the United
States; and Saudi Arabia has concluded special lending arrangements
with the IMF associated with the IMF's General Arrangements to
Borrow.
---------------------------------------------------------------------------
Section 1750.3 Procedures and Timing
Section 1750.3 provides that each Enterprise must file with the
Director a minimum capital report each quarter, or at such other times
as the Director requires, in his or her sole discretion. The report
must contain the information that responds to all of the items required
by OFHEO in written instructions to the Enterprise, including, but not
limited to an estimate of the minimum capital requirement; an estimate
of core capital overage or shortfall relative to the estimated minimum
capital requirement; and such other information as may be required by
the Director.
This section further provides that the report must be submitted not
later than April 30, July 30, October 30, and January 30 of each year,
and that it must be in writing and in such other format as may be
required by the Director.
In the event an Enterprise makes an adjustment to its financial
statements for a quarter or a date for which the information was
requested which would cause an adjustment to a minimum capital report,
section 1750.3 requires that the Enterprise file an amended minimum
capital report not later than 3 business days after the date of such
adjustment.
Finally, section 1750.3 provides that each minimum capital report
or any amended minimum capital report must contain a declaration by an
officer authorized by the board of directors of the Enterprise to make
such a declaration, including, but not limited to, a president, vice
president, or treasurer, that the report is true and correct to the
best of such officer's knowledge and belief.
Section 1750.4 Minimum Capital Requirement Computation
Section 1750.4 sets forth the methodology for computing the minimum
capital requirement. The minimum capital requirement is the sum of the
following amounts:
--2.50 percent times the aggregate on-balance sheet assets of the
Enterprise;
--0.45 percent times the unpaid principal balance of mortgage-backed
securities and substantially equivalent instruments that were issued or
guaranteed by the Enterprise;
--0.45 percent of 50 percent of the average dollar amount of
commitments outstanding each quarter over the preceding four quarters;
--0.45 percent of the outstanding principal amount of bonds with
multifamily credit enhancements;
--0.45 percent of the dollar amount of sold portfolio remittances
pending;
[[Page 35618]]
--3.00 percent of the credit equivalent amount of interest rate
contracts and foreign exchange rate contracts, except to the extent of
the current market value of posted qualifying collateral, computed in
accordance with Appendix A; 1.50 percent of the market value of
qualifying collateral posted to secure interest rate and foreign
exchange rate contracts, not to exceed the credit equivalent amount of
such contracts, computed in accordance with Appendix A; and
--0.45 percent of the outstanding amount, credit equivalent amount, or
other measure determined appropriate by the Director, of other off-
balance sheet obligations (excluding commitments, multifamily credit
enhancements, sold portfolio remittances pending, and interest rate
contracts and foreign exchange rate contracts), except as adjusted by
the Director to reflect differences in the credit risk of such
obligations in relation to mortgage-backed securities.
In the event that any asset or financial obligation is properly
classifiable in more than one of the above categories, section 1750.4
provides that, for minimum capital purposes, the asset or financial
obligation must be classified in the category that yields the highest
minimum capital requirement.
The section further explains that the term ``preceding four
quarters'' means the last day of the quarter just ended (or the date
for which the minimum capital report is filed, if different), and the
three preceding quarter-ends.
Section 1750.5 Notice of Capital Classification
Section 1750.5 states that not later than 60 calendar days after
the date for which the minimum capital report is filed, OFHEO will
provide each Enterprise with a notice of proposed capital
classification in accordance with section 1368 of the 1992 Act.33
The notice of proposed capital classification includes the proposed
minimum capital requirement and the summary computation of the proposed
minimum capital requirement.
---------------------------------------------------------------------------
\33\ 12 U.S.C. 4618.
---------------------------------------------------------------------------
Each Enterprise has a period of 30 calendar days following receipt
of a notice of proposed capital classification to submit a response.
The response period may be extended for up to 30 additional calendar
days at the sole discretion of the Director. The Director may shorten
the response period with the consent of the Enterprise or without such
consent if the Director determines that the condition of the Enterprise
requires a shorter response period.
Section 1750.5 further provides that the Director must take into
consideration any response to the notice of proposed capital
classification received from the Enterprise and must issue a notice of
final capital classification for each Enterprise not later than 30
calendar days following the end of the response period.
Appendix A to Subpart A of Part 1750--Minimum Capital Components for
Interest Rate and Foreign Exchange Rate Contracts
Calculation of Credit Equivalent Amounts
Appendix A provides that the minimum capital components for
interest rate and foreign exchange rate contracts are computed on the
basis of the credit equivalent amounts of such contracts. The credit
equivalent amount of an off-balance sheet interest rate or foreign
exchange rate contract that is not subject to a qualifying bilateral
netting contract in accordance with Appendix A is equal to the sum of
the current exposure (sometimes referred to as the replacement cost) of
the contract and an estimate of the potential future credit exposure
over the remaining life of the contract.
The current exposure is determined by the mark-to-market value of
the contract. If the mark-to-market value is positive, then the current
exposure is the mark-to-market value. If the mark-to-market value is
zero or negative, then the current exposure is zero. Mark-to-market
values are measured in United States dollars, regardless of the
currency or currencies specified in the contract, and should reflect
changes in the relevant rates as well as counterparty credit quality.
The potential future credit exposure of a contract, including a
contract with a negative mark-to-market value, is estimated by
multiplying the notional principal amount of the contract by a credit
conversion factor. The effective rather than the apparent or stated
notional amount must be used in this calculation. The credit conversion
factors for interest rate contracts are 0.0 percent for interest rate
contracts with a remaining maturity of 1 year or less; 0.5 percent for
interest rate contracts with a remaining maturity of over 1 year; 1.0
percent for foreign exchange rate contracts with a remaining maturity
of 1 year or less; and 5.0 percent for foreign exchange rate contracts
with a remaining maturity of over 1 year.
Because foreign exchange rate contracts involve an exchange of
principal upon maturity, and foreign exchange rates are generally more
volatile than interest rates, higher conversion factors have been
established for foreign exchange rate contracts than for interest rate
contracts.
No potential future credit exposure is calculated for single
currency interest rate swaps in which payments are made based upon two
floating rate indexes, so-called floating/floating or basis swaps. The
credit exposure on these contracts is evaluated solely on the basis of
their mark-to-market values.
Avoidance of Double Counting
Appendix A provides that, in certain cases, credit exposures
arising from the interest rate and foreign exchange rate contracts
covered by this Appendix A may already be reflected, in part, on the
balance sheet. To avoid double counting such exposures in the
assessment of capital adequacy, counterparty credit exposures arising
from the types of instruments covered by this Appendix A may need to be
excluded from balance sheet assets in calculating the minimum capital
requirement.
Collateral
Appendix A provides that the sufficiency of collateral for off-
balance sheet items is determined by the market value of the collateral
in relation to the credit equivalent amount. Collateral held against a
netting contract is not recognized for minimum capital standard
purposes unless it is legally available to support the single legal
obligation created by the netting contract. Excess collateral held
against one contract or a group of contracts for which a recognized
netting agreement exists may not be considered.
The only forms of collateral that are formally recognized by the
minimum capital standard framework are cash on deposit; securities
issued or guaranteed by the central governments of the OECD-based group
of countries, United States Government agencies, or United States
Government-sponsored agencies; and securities issued by multilateral
lending institutions or regional development banks.
Netting
For purposes of Appendix A, netting refers to the offsetting of
positive and negative mark-to-market values in the determination of a
current exposure to be used in the calculation of a credit equivalent
amount. Any legally enforceable form of bilateral netting (that is,
netting with a single counterparty) of interest rate and foreign
exchange rate contracts is recognized for purposes of calculating the
credit equivalent amount if it meets the following requirements.
Netting is
[[Page 35619]]
accomplished under a written netting contract that creates a single
legal obligation, covering all included individual contracts, with the
effect that the Enterprise would have a claim to receive, or obligation
to pay, only the net amount of the sum of the positive and negative
mark-to-market values on included individual contracts in the event
that a counterparty, or a counterparty to whom the contract has been
validly assigned, fails to perform due to default, insolvency,
liquidation, or similar circumstances.
The Enterprise must obtain a written and reasoned legal opinion(s)
representing that in the event of a legal challenge--including one
resulting from default, insolvency, liquidation, or similar
circumstances--the relevant court and administrative authorities would
find the Enterprise's exposure to be such a net amount under--
--the law of the jurisdiction in which the counterparty is chartered or
the equivalent location in the case of noncorporate entities, and if a
branch of the counterparty is involved, then also under the law of the
jurisdiction in which the branch is located;
--the law that governs the individual contracts covered by the netting
contract; and
--the law that governs the netting contract.
The Enterprise must establish and maintain procedures to ensure
that the legal characteristics of netting contracts are kept under
review in the event of possible changes in relevant law. Furthermore,
the Enterprise must maintain in its files documentation adequate to
support the netting of rate contracts, including a copy of the
bilateral netting contract and necessary legal opinions.
A contract containing a walkaway clause is not eligible for netting
for purposes of calculating the credit equivalent amount. A walkaway
clause is a provision in a netting contract that permits a non-
defaulting counterparty to make lower payments than it would make
otherwise under the contract, or no payment at all, to a defaulter or
to the estate of a defaulter, even if the defaulter or the estate of
the defaulter is a net creditor under the contract.
By netting individual contracts for the purpose of calculating its
credit equivalent amount, the Enterprise represents that it has met the
requirements of Appendix A, and that all the appropriate documents are
in the Enterprise's files and available for inspection by OFHEO. OFHEO
may determine that an Enterprise's files are inadequate or that a
netting contract, or any of its underlying individual contracts, may
not be legally enforceable under any one of the bodies of law described
in Appendix A. If such a determination is made, the netting contract
may be disqualified from recognition for minimum capital standard
purposes or underlying individual contracts may be treated as though
they are not subject to the netting contract.
The credit equivalent amount of interest rate and foreign exchange
rate contracts that are subject to a qualifying bilateral netting
contract is calculated by adding the current exposure of the netting
contract and the sum of the estimates of the potential future credit
exposures on all individual contracts subject to the netting contract,
estimated in accordance with Appendix A. Offsetting contracts in the
same currency maturing on the same date will have lower potential
future exposure as well as lower current exposure. Therefore, for
purposes of calculating potential future credit exposure to a netting
counterparty for foreign exchange rate contracts, and other similar
contracts in which notional principal is equivalent to cash flows,
total notional principal is defined as the net receipts falling due on
each value date in each currency.
The current exposure of the netting contract is determined by
summing all positive and negative mark-to-market values of the
individual contracts included in the netting contract. If the net sum
of the mark-to-market values is positive, then the current exposure of
the netting contract is equal to that sum. If the net sum of the mark-
to-market values is zero or negative, then the current exposure of the
netting contract is zero. OFHEO may determine that a netting contract
qualifies for netting treatment even though certain individual
contracts may not qualify. In such instances, the nonqualifying
contracts should be treated as individual contracts that are not
subject to the netting contract.
In the event a netting contract covers contracts that are normally
excluded from the minimum capital requirement computation--for example,
foreign exchange rate contracts with an original maturity of 14
calendar days or less, or instruments traded on exchanges that require
daily payment of variation margin--an Enterprise may elect consistently
either to include or exclude all mark-to-market values of such
contracts when determining net current exposure.
As stated in the preamble to the proposed regulation, in developing
Appendix A, OFHEO considered provisions of the regulations of the
federal banking agencies with respect to the calculation of the credit
equivalent amount for interest rate and foreign exchange rate
contracts. Subsequent to the publication of the proposed Minimum
Capital regulation, the federal banking agencies amended their
regulations with respect to interest rate and foreign exchange rate
contracts.34 The amendments increase the number of credit
conversion factors that are used to measure the potential future credit
exposure of interest rate and foreign exchange rate contracts. They
also change the way the potential future credit exposure is calculated
when the interest rate and foreign exchange rate contracts are subject
to a qualifying bilateral netting agreement, resulting in a reduction
in the amount of capital required for the netted interest rate and
foreign exchange rate contracts.
---------------------------------------------------------------------------
\34\ 60 FR 46170 (Sept. 5, 1995).
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OFHEO is analyzing those amendments and considering whether to
conform Appendix A to the final regulations of the federal banking
agencies. Based on the results of that analysis, OFHEO will publish a
proposal, as appropriate.
Regulatory Impact
Executive Order 12606, The Family
This regulation does not have potential for significant impact on
family formulation, maintenance, and general well-being, and thus is
not subject to review under Executive Order 12606.
Executive Order 12612, Federalism
This regulation has no federalism implications that warrant the
preparation of a Federalism Assessment in accordance with Executive
Order 12612.
Executive Order 12866, Regulatory Planning and Review
This regulation has been reviewed by the Office of Management and
Budget pursuant to Executive Order 12866.
Executive Order 12988, Civil Justice Reform
This proposed regulation meets the applicable standards of sections
3(a) and (b) of Executive Order 12988.
Unfunded Mandates Reform Act of 1995
The regulation does not require the preparation of an assessment
statement in accordance with the Unfunded Mandates Reform Act of 1995.
Assessment statements are not required for regulations that incorporate
requirements specifically set forth in
[[Page 35620]]
law. As explained in the preamble, this regulation implements the
minimum capital standard contained in the 1992 Act. In addition, this
regulation does not include a federal mandate that may result in the
expenditure by State, local, and tribal governments, in the aggregate,
or by the private sector, of $100,000,000 or more (adjusted annually
for inflation) in any 1 year.
Regulatory Flexibility Act
This regulation is applicable only to the Enterprises, which are
not small entities for purposes of the Regulatory Flexibility Act, and
does not have a significant effect on a substantial number of small
entities. Therefore, the General Counsel of OFHEO has certified that
the final regulation will not have significant economic impact on a
substantial number of small entities.
Paperwork Reduction Act
This regulation contains no information collection requirements
that require the approval of the Office of Management and Budget
pursuant to the Paperwork Reduction Act of 1980, 44 U.S.C. 3501 et seq.
List of Subjects in 12 CFR Part 1750
Banks, banking, Federal Home Loan Mortgage Corporation, Federal
National Mortgage Association, Mortgages, Securities.
Accordingly, for the reasons set forth in the preamble, OFHEO
amends Chapter XVII of Title 12 of the Code of Federal Regulations by
adding Part 1750 to read as follows:
PART 1750--CAPITAL
Subpart A--Minimum Capital
Sec.
1750.1 General.
1750.2 Definitions.
1750.3 Procedure and timing.
1750.4 Minimum capital requirement computation.
1750.5 Notice of capital classification.
Appendix A to Subpart A of Part 1750--Minimum Capital Components for
Interest Rate and Foreign Exchange Rate Contracts
Subpart B--[Reserved]
Authority: 12 U.S.C. 4513, 4514, 4612, 4614, 4618.
Subpart A--Minimum Capital
Sec. 1750.1 General.
The regulation contained in this subpart A sets forth the
methodology for computing the minimum capital requirement for each
Enterprise. The board of directors of each Enterprise is responsible
for ensuring that the Enterprise maintains capital at a level that is
sufficient to ensure the continued financial viability of the
Enterprise and that equals or exceeds the minimum capital requirement
contained in this subpart A.
Sec. 1750.2 Definitions.
For purposes of this subpart A, the following definitions shall
apply:
Affiliate means any entity that controls, is controlled by, or is
under common control with, an Enterprise, except as otherwise provided
by the Director.
Commitment means any contractual, legally binding agreement that
obligates an Enterprise to purchase or to securitize mortgages.
Core Capital--(1) Means the sum of (as determined in accordance
with generally accepted accounting principles)--
(i) The par or stated value of outstanding common stock;
(ii) The par or stated value of outstanding perpetual,
noncumulative preferred stock;
(iii) Paid-in capital; and
(iv) Retained earnings; and
(2) Does not include debt instruments or any amounts the Enterprise
could be required to pay at the option of an investor to retire capital
instruments.
Director means the Director of OFHEO.
Enterprise means the Federal National Mortgage Association and any
affiliate thereof or the Federal Home Loan Mortgage Corporation and any
affiliate thereof.
Foreign exchange rate contracts--
(1) Means cross-currency interest rate swaps, forward foreign
exchange contracts, currency options purchased (including currency
options purchased over-the-counter), and any other instrument that
gives rise to similar credit risks; and
(2) Does not mean foreign exchange rate contracts with an original
maturity of 14 calendar days or less and foreign exchange rate
contracts traded on exchanges that require daily payment of variation
margins.
Interest rate contracts--
(1) Means single currency interest rate swaps, basis swaps, forward
rate agreements, interest rate options purchased (including caps,
collars, and floors purchased), over-the-counter options purchased, and
any other instrument that gives rise to similar credit risks (including
when-issued securities and forward deposits accepted); and
(2) Does not mean such instruments traded on exchanges that require
daily payment of variation margins.
Mortgage-backed security means a security, investment, or
substantially equivalent instrument that represents an interest in a
pool of loans secured by mortgages or deeds of trust where the
principal or interest payments to the investor in the security or
substantially equivalent instrument are guaranteed or effectively
guaranteed by an Enterprise.
Multifamily credit enhancement means any guarantee, pledge,
purchase arrangement, or other obligation or commitment provided or
entered into by an Enterprise with respect to multifamily mortgages to
provide credit enhancement, liquidity, interest rate support, and other
guarantees and enhancements for revenue bonds issued by a state or
local governmental unit (including a housing finance agency) or other
bond issuer.
1992 Act means the Federal Housing Enterprises Financial Safety and
Soundness Act of 1992, found at Title XIII of the Housing and Community
Development Act of 1992, Pub. L. 102-550, 12 U.S.C. 4501 et seq.
Notional amount means the face value of the underlying financial
instrument(s) on which an interest rate or foreign exchange rate
contract is based.
Off-balance sheet obligation means a binding agreement, contract,
or similar arrangement that requires or may require future payment(s)
in money or kind by another party to an Enterprise, or that effectively
guarantees all or part of such payment(s) to third parties (including
commitments), where such agreement or contract is a source of credit
risk that is not included on its balance sheet.
OFHEO means the Office of Federal Housing Enterprise Oversight.
Other off-balance sheet obligations means all off-balance sheet
obligations of an Enterprise that are not mortgage-backed securities or
substantially equivalent instruments and that are not resecuritized
mortgage-backed securities, such as real estate mortgage investment
conduits or similar resecuritized instruments.
Perpetual, noncumulative preferred stock means preferred stock
that--
(1) Does not have a maturity date;
(2) Provides the issuer the ability and the legal right to
eliminate dividends and does not permit the accruing or payment of
impaired dividends;
(3) Cannot be redeemed at the option of the holder; and
(4) Has no other provisions that will require future redemption of
the issue, in whole or in part, or that will reset the dividend
periodically based, in whole or in part, on the Enterprise's current
credit standing, such as auction rate,
[[Page 35621]]
money market, or remarketable preferred stock, or that may cause the
dividend to increase to a level that could create an incentive for the
issuer to redeem the instrument, such as exploding rate stock.
Qualifying collateral means cash on deposit; securities issued or
guaranteed by the central governments of the OECD-based group of
countries,1 United States Government agencies, or United States
Government-sponsored agencies; and securities issued by multilateral
lending institutions or regional development banks.
---------------------------------------------------------------------------
\1\ The OECD-based group of countries comprises full members of
the Organization for Economic Cooperation and Development (OECD)
regardless of entry date, as well as countries that have concluded
special lending arrangements with the International Monetary Fund
(IMF) associated with the IMF's General Arrangements to Borrow, but
excludes any country that has rescheduled its external sovereign
debt within the previous 5 years. A rescheduling of external
sovereign debt generally would include any renegotiation of terms
arising from a country's mobility or unwillingness to meet its
external debt service obligations, but generally not include any
renegotiation to allow the borrower to take advantage of a decline
in interest rate or other change in market conditions. As of
November 1995, the OECD countries included the following countries:
Australia, Austria, Belgium, Canada, Denmark, Finland, France,
Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, Mexico,
the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden,
Switzerland, Turkey, the United Kingdom, and the United States; and
Saudi Arabia has concluded special lending arrangements with the IMF
associated with the IMF's General Arrangements to Borrow.
---------------------------------------------------------------------------
Sec. 1750.3 Procedure and timing.
(a) Each Enterprise shall file with the Director a minimum capital
report each quarter or at such other times as the Director requires, in
his or her sole discretion. The report shall contain the information
that responds to all of the items required by OFHEO in written
instructions to the Enterprise, including, but not limited to:
(1) Estimate of the minimum capital requirement;
(2) Estimate of core capital overage or shortfall relative to the
estimated minimum capital requirement;
(3) Such other information as may be required by the Director.
(b) The quarterly minimum capital report shall be submitted not
later than April 30, July 30, October 30, and January 30 of each year.
(c) Each minimum capital report shall be submitted in writing and
in such other format as may be required by the Director.
(d) In the event an Enterprise makes an adjustment to its financial
statements for a quarter or a date for which the information was
requested, which would cause an adjustment to a minimum capital report,
the Enterprise shall file with the Director an amended minimum capital
report not later than 3 business days after the date of such
adjustment.
(e) Each minimum capital report or any amended minimum capital
report shall contain a declaration by an officer authorized by the
board of directors of the Enterprise to make such a declaration,
including, but not limited to a president, vice president, or
treasurer, that the report is true and correct to the best of such
officer's knowledge and belief.
Sec. 1750.4 Minimum capital requirement computation.
(a) The minimum capital requirement for each Enterprise shall be
computed by adding the following amounts:
(1) 2.50 percent times the aggregate on-balance sheet assets of the
Enterprise;
(2) 0.45 percent times the unpaid principal balance of mortgage-
backed securities and substantially equivalent instruments that were
issued or guaranteed by the Enterprise;
(3) 0.45 percent of 50 percent of the average dollar amount of
commitments outstanding each quarter over the preceding four quarters;
(4) 0.45 percent of the outstanding principal amount of bonds with
multifamily credit enhancements;
(5) 0.45 percent of the dollar amount of sold portfolio remittances
pending;
(6)(i) 3.00 percent of the credit equivalent amount of interest
rate contracts and foreign exchange rate contracts, except to the
extent of the current market value of posted qualifying collateral,
computed in accordance with appendix A to this subpart;
(ii) 1.50 percent of the market value of qualifying collateral
posted to secure interest rate and foreign exchange rate contracts, not
to exceed the credit equivalent amount of such contracts, computed in
accordance with appendix A to this subpart; and
(7) 0.45 percent of the outstanding amount, credit equivalent
amount, or other measure determined appropriate by the Director, of
other off-balance sheet obligations (excluding commitments, multifamily
credit enhancements, sold portfolio remittances pending, and interest
rate contracts and foreign exchange rate contracts), except as adjusted
by the Director to reflect differences in the credit risk of such
obligations in relation to mortgage-backed securities.
(b) Any asset or financial obligation that is properly classifiable
in more than one of the categories enumerated in paragraphs (a) (1)
through (7) of this section shall be classified in the category that
yields the highest minimum capital requirement.
(c) As used in this section, the term ``preceding four quarters''
means the last day of the quarter just ended (or the date for which the
minimum capital report is filed, if different), and the three preceding
quarter-ends.
Sec. 1750.5 Notice of capital classification.
(a) Pursuant to section 1364 of the 1992 Act (12 U.S.C. 4614),
OFHEO is required to determine the capital classification of each
Enterprise on a not less than quarterly basis.
(b) The determination of the capital classification shall be made
following a notice to, and opportunity to respond by, the Enterprise.
(1) Not later than 60 calendar days after the date for which the
minimum capital report is filed, OFHEO will provide each Enterprise
with a notice of proposed capital classification in accordance with
section 1368 of the 1992 Act (12 U.S.C. 4618). The notice shall contain
the following information--
(i) The proposed capital classification;
(ii) The proposed minimum capital requirement; and
(iii) The summary computation of the proposed minimum capital
requirement.
(2) Each Enterprise shall have a period of 30 calendar days
following receipt of a notice of proposed capital classification to
submit a response regarding the proposed capital classification. The
response period may be extended for up to 30 additional calendar days
at the sole discretion of the Director. The Director may shorten the
response period with the consent of the Enterprise, or without such
consent if the Director determines that the condition of the Enterprise
requires a shorter period.
(3) The Director shall take into consideration any response to the
notice of proposed capital classification received from the Enterprise
and shall issue a notice of final capital classification for each
Enterprise not later than 30 calendar days following the end of the
response period in accordance with section 1368 of the 1992 Act (12
U.S.C. 4618).
Appendix A to Subpart A of Part 1750--Minimum Capital Components for
Interest Rate and Foreign Exchange Rate Contracts
1. The minimum capital components for interest rate and foreign
exchange rate contracts are computed on the basis of the credit
equivalent amounts of such contracts. Credit equivalent amounts are
computed for each of the following off-balance sheet
[[Page 35622]]
interest rate and foreign exchange rate contracts:
a. Interest Rate Contracts
i. Single currency interest rate swaps.
ii. Basis swaps.
iii. Forward rate agreements.
iv. Interest rate options purchased (including caps, collars,
and floors purchased).
v. Any other instrument that gives rise to similar credit risks
(including when-issued securities and forward deposits accepted).
b. Foreign Exchange Rate Contracts
i. Cross-currency interest rate swaps.
ii. Forward foreign exchange rate contracts.
iii. Currency options purchased.
iv. Any other instrument that gives rise to similar credit
risks.
2. Foreign exchange rate contracts with an original maturity of
14 calendar days or less and foreign exchange rate contracts traded
on exchanges that require daily payment of variation margins are
excluded from the minimum capital requirement computation. Over-the-
counter options purchased, however, are included and treated in the
same way as the other interest rate and foreign exchange rate
contracts.
3. Calculation of Credit Equivalent Amounts
a. The minimum capital components for interest rate and foreign
exchange rate contracts are computed on the basis of the credit
equivalent amounts of such contracts. The credit equivalent amount
of an off-balance sheet interest rate and foreign exchange rate
contract that is not subject to a qualifying bilateral netting
contract in accordance with this appendix A is equal to the sum of
the current exposure (sometimes referred to as the replacement cost)
of the contract and an estimate of the potential future credit
exposure over the remaining life of the contract.
b. The current exposure is determined by the mark-to-market
value of the contract. If the mark-to-market value is positive, then
the current exposure is the mark-to-market value. If the mark-to-
market value is zero or negative, then the current exposure is zero.
Mark-to-market values are measured in United States dollars,
regardless of the currency or currencies specified in the contract,
and should reflect changes in the relevant rates, as well as
counterparty credit quality.
c. The potential future credit exposure of a contract, including
a contract with a negative mark-to-market value, is estimated by
multiplying the notional principal amount of the contract by a
credit conversion factor. The effective rather than the apparent or
stated notional amount must be used in this calculation. The credit
conversion factors are:
------------------------------------------------------------------------
Foreign
Interest rate exchange rate
Remaining maturity contracts contracts
(percent) (percent)
------------------------------------------------------------------------
1 year or less............................ 0.0 1.0
Over 1 year............................... 0.5 5.0
------------------------------------------------------------------------
d. Because foreign exchange rate contracts involve an exchange
of principal upon maturity, and foreign exchange rates are generally
more volatile than interest rates, higher conversion factors have
been established for foreign exchange rate contracts than for
interest rate contracts.
e. No potential future credit exposure is calculated for single
currency interest rate swaps in which payments are made based upon
two floating rate indexes, so-called floating/floating or basis
swaps. The credit exposure on these contracts is evaluated solely on
the basis of their mark-to-market values.
4. Avoidance of Double Counting
In certain cases, credit exposures arising from the interest
rate and foreign exchange instruments covered by this appendix A may
already be reflected, in part, on the balance sheet. To avoid double
counting such exposures in the assessment of capital adequacy,
counterparty credit exposures arising from the types of instruments
covered by this appendix A may need to be excluded from balance
sheet assets in calculating the minimum capital requirement.
5. Collateral
a. The sufficiency of collateral for off-balance sheet items is
determined by the market value of the collateral in relation to the
credit equivalent amount. Collateral held against a netting contract
is not recognized for minimum capital standard purposes unless it is
legally available to support the single legal obligation created by
the netting contract. Excess collateral held against one contract or
a group of contracts for which a recognized netting agreement exists
may not be considered.
b. The only forms of collateral that are formally recognized by
the minimum capital standard framework are cash on deposit;
securities issued or guaranteed by the central governments of the
OECD-based group of countries, United States Government agencies, or
United States Government-sponsored agencies; and securities issued
by multilateral lending institutions or regional development banks.
6. Netting
a. For purposes of this appendix A, netting refers to the
offsetting of positive and negative mark-to-market values in the
determination of a current exposure to be used in the calculation of
a credit equivalent amount. Any legally enforceable form of
bilateral netting (that is, netting with a single counterparty) of
interest rate and foreign exchange rate contracts is recognized for
purposes of calculating the credit equivalent amount provided that
the following criteria are met:
i. Netting must be accomplished under a written netting contract
that creates a single legal obligation, covering all included
individual contracts, with the effect that the Enterprise would have
a claim to receive, or obligation to pay, only the net amount of the
sum of the positive and negative mark-to-market values on included
individual contracts in the event that a counterparty, or a
counterparty to whom the contract has been validly assigned, fails
to perform due to default, insolvency, liquidation, or similar
circumstances.
ii. The Enterprise must obtain a written and reasoned legal
opinion(s) representing that in the event of a legal challenge--
including one resulting from default, insolvency, liquidation, or
similar circumstances--the relevant court and administrative
authorities would find the Enterprise's exposure to be such a net
amount under--
A. The law of the jurisdiction in which the counterparty is
chartered or the equivalent location in the case of noncorporate
entities, and if a branch of the counterparty is involved, then also
under the law of the jurisdiction in which the branch is located;
B. The law that governs the individual contracts covered by the
netting contract; and
C. The law that governs the netting contract.
iii. The Enterprise must establish and maintain procedures to
ensure that the legal characteristics of netting contracts are kept
under review in the event of possible changes in relevant law.
iv. The Enterprise must maintain in its files documentation
adequate to support the netting of rate contracts, including a copy
of the bilateral netting contract and necessary legal opinions.
b. A contract containing a walkaway clause is not eligible for
netting for purposes of calculating the credit equivalent
amount.1
---------------------------------------------------------------------------
\1\ A walkaway clause is a provision in a netting contract that
permits a non-defaulting counterparty to make lower payments than it
would make otherwise under the contract, or no payment at all, to a
defaulter or to the estate of a defaulter, even if the defaulter or
the estate of the defaulter is a net creditor under the contract.
---------------------------------------------------------------------------
c. By netting individual contracts for the purpose of
calculating its credit equivalent amount, the Enterprise represents
that it has met the requirements of this appendix A and all the
appropriate documents are in the Enterprise's files and available
for inspection by OFHEO. OFHEO may determine that an Enterprise's
files are inadequate or that a netting contract, or any of its
underlying individual contracts, may not be legally enforceable
under any one of the bodies of law described in this appendix A. If
such a determination is made, the netting contract may be
disqualified from recognition for minimum capital standard purposes
or underlying individual contracts may be treated as though they are
not subject to the netting contract.
d. The credit equivalent amount of interest rate and foreign
exchange rate contracts that are subject to a qualifying bilateral
netting contract is calculated by adding the current exposure of the
netting contract and the sum of the estimates of the potential
future credit exposures on all individual contracts subject to the
netting contract, estimated in accordance with paragraph 3 of this
appendix A. Offsetting contracts in the same currency maturing on
the same date will have lower potential future exposure as well as
lower current exposure. Therefore, for purposes of calculating
potential future credit exposure to a netting counterparty for
foreign exchange rate contracts and other similar contracts in which
notional principal
[[Page 35623]]
is equivalent to cash flows, total notional principal is defined as
the net receipts falling due on each value date in each currency.
e. The current exposure of the netting contract is determined by
summing all positive and negative mark-to-market values of the
individual contracts included in the netting contract. If the net
sum of the mark-to-market values is positive, then the current
exposure of the netting contract is equal to that sum. If the net
sum of the mark-to-market values is zero or negative, then the
current exposure of the netting contract is zero. OFHEO may
determine that a netting contract qualifies for minimum capital
standard netting treatment even though certain individual contracts
may not qualify. In such instances, the nonqualifying contracts
should be treated as individual contracts that are not subject to
the netting contract.
f. In the event a netting contract covers contracts that are
normally excluded from the minimum capital requirement computation--
for example, foreign exchange rate contracts with an original
maturity of 14 calendar days or less, or instruments traded on
exchanges that require daily payment of variation margin--an
Enterprise may elect consistently either to include or exclude all
mark-to-market values of such contracts when determining net current
exposure.
Subpart B--[Reserved]
Aida Alvarez,
Director, Office of Federal Housing Enterprise Oversight.
[FR Doc. 96-17120 Filed 7-5-96; 8:45 am]
BILLING CODE 4220-01-P
