United States General Accounting Office

GAO Testimony

Before the Subcommittee on Capital Markets,

Securities and Government Sponsored Enterprises

Committee on Banking and Financial Services

House of Representatives

Not to be Released Before

10:00 a.m. EDT

Wednesday

July 31, 1996

HOUSING ENTERPRISES

Assessment of OFHEO’s

Interest Rate Analysis

Statement for the Record

James L. Bothwell, Director

Financial Institutions and Markets Issues

General Government Division

G O A

years

1921 - 1996

GAO/T-GGD-96-173

Statement

Mr. Chairman and Members of the Subcommittee:

On July 5, 1996, the Subcommittee on Capital Markets, Securities and

Government Sponsored Enterprises of the House Committee on Banking

and Financial Services requested that the Office of Federal Housing

Enterprise Oversight (OFHEO) analyze the potential effects of a large and

rapid increase in interest rates, accompanied by otherwise unfavorable

economic conditions, on the financial condition of Fannie Mae and

Freddie Mac (the enterprises). The Subcommittee requested that we

review OFHEO’s analysis and assess the reasonableness of the approach and

key assumptions that OFHEO used in its analysis.

OFHEO used two approaches to address the Subcommittee’s request. First,

OFHEO asked the enterprises to use their own financial models to project

the impacts of interest rate changes and credit conditions specified by

OFHEO. Second, OFHEO used its financial models, which are under

development to respond to a statutory mandate to establish risk-based

capital standards for the enterprises. This mandate was contained in the

Federal Housing Enterprises Financial Safety and Soundness Act of 1992

(the 1992 Act). OFHEO analyzed two scenarios with each approach, one

called a “wind down” scenario with no new business over a period of 10

years and a second scenario with specified projections of new business.

To monitor and assess OFHEO’s analysis, we met extensively with OFHEO

staff. In these meetings, we discussed the assumptions and the workings

of OFHEO’s financial models. We also discussed the enterprises’ financial

models with both OFHEO and enterprise staff. We did not verify the data

used in nor the structure of the financial models used by OFHEO, Fannie

Mae, or Freddie Mac. To help us judge the reasonableness of assumptions,

we also consulted economic and financial literature. We did our work in

June and July in Washington, D.C., in accordance with generally accepted

government auditing standards.

Both approaches made projections over a 10-year period and required the

use of key assumptions. The Subcommittee had specified a 600 basis point1

 increase in interest rates on U.S. Treasury securities over a period of 18

months. OFHEO assumed that after the 18 month increase in interest rates,

these Treasury rates would remain constant for the remaining 8-1/2 years

of the 10-year stress period.

1

A basis point is one one-hundredth of a percentage point.

Page 1 GAO/T-GGD-96-173
Statement

In addition to the sustained 18-month interest rate increase, the

Subcommittee asked that the analysis assume that credit losses were

simultaneously high or severe, as might be the case if the higher interest

rates were not accompanied by an increase in the general inflation rate.

OFHEO specified which particular credit loss assumptions would be used in

the analysis. Generally, the credit loss assumptions OFHEO supplied to the

enterprises specified losses on existing mortgages purchased by the

enterprises that would exhaust minimum capital, loan loss reserves, and

guarantee fee income, on a present-value basis, over the 10-year stress

period. Credit losses on any new business over the 10-year period were

assumed to be consistent with credit losses on existing business. Both

OFHEO and Freddie Mac officials told us that the loss assumptions specified

by OFHEO would be equivalent to about 30 basis points in credit losses on

purchased mortgages.

OFHEO also directed the enterprises to assume an additional 50 basis point

increase in enterprise debt costs, beginning in the third year of the stress

period, to reflect potential investor concerns about possible default. In

addition, OFHEO specified that annual increases in guarantee fees, starting

in the third year of the stress period, could not exceed 2 basis points.

Under these assumptions, net interest margins on new enterprise business

and the growth of new business could not be the basis for alleviating or

reversing the projected impacts of the interest rate increase and credit

losses on existing business.

The financial models used by OFHEO, Fannie Mae, and Freddie Mac differed

in both the assumptions and the relationships embodied in the models. For

example, the three models contain different assumptions about the impact

of an interest rate increase on prepayment rates by borrowers.2

 In addition

to differences in the three sets of financial models used in OFHEO’s two

approaches, each approach had its own limitations. The approach that

relied on the enterprises’ models was constrained because OFHEO was

dealing with the enterprises’ models through the enterprises rather than

directly. This resulted in a significant amount of interchange with

enterprise analysts over a short period of time to establish detailed

assumptions on items such as general and administrative expenses and net

income on short-term investments. OFHEO was limited in the second

approach because its own modeling work for the statutory stress test,

including the normalization of enterprise accounting data, had not been

2

A prepayment occurs when the borrower pays off the remaining principal on a loan before the full

term of the loan (e.g., 30 years) has been reached.

Page 2 GAO/T-GGD-96-173
Statement

completed. This exercise was the first statistical use of OFHEO’s financial

models.

Enterprise officials stated that, in their view, the combination of higher

interest rates and the credit stress specified by OFHEO in the first approach

was not reasonable. In particular, both enterprises believed that the

increase in interest rates would likely be accompanied by increased

inflation, greater home price appreciation, and subsequent declines in

credit losses. For example, Freddie Mac officials told us that a credit

stress with 10 basis points in credit losses would be more appropriate for

the Subcommittee’s request than that specified by OFHEO, which was

equivalent to a 30 basis point loss. These officials also told us that current

losses from credit risk on Freddie Mac mortgages were equivalent to about

10 to 11 basis points. Fannie Mae officials told us that the OFHEO-specified

contraction in earnings on new business was circular; the additional 50

basis point increase in borrowing costs was based on a stressful situation

that was not realistic.

We believe, in light of the constraints and limitations discussed above, that

the approach undertaken by OFHEO to comply with the Subcommittee

request was reasonable. We also believe that the key assumptions on

interest rate movements and accompanying credit losses, while severe,

appear reasonable for achieving the purpose of a stress test. Such tests are

designed to estimate the effects of adverse conditions, which are not

necessarily the most probable or likely conditions.

There are at least two reasons why we believe it was reasonable for OFHEO

to assume that an interest rate increase need not be accompanied by a

general increase in prices. First, past experience has shown that interest

rates can rise by more than the inflation rate. Second, home prices do not

necessarily increase at the general rate of inflation. In addition, the

Subcommittee specifically asked that the interest rate increase not be

assumed to result from a general increase in inflation.

We also believe that OFHEO’s specification of an additional 50 basis point

increase in enterprise debt costs is reasonable because it is consistent

with the experiences of Fannie Mae during the early 1980s and the Farm

Credit System during the mid-1980s when each experienced financial

difficulty.3

 It also appears reasonable for OFHEO to assume that the

enterprises could not increase guarantee fees by more than 2 basis points

3

See Government-Sponsored Enterprises: The Government’s Exposure to Risks (GAO/GGD-90-97,

Aug. 1990) p. 87.

Page 3 GAO/T-GGD-96-173
Statement

annually in response to an increase in credit losses, because of

competition from other providers of residential mortgage credit.

We believe the analysis requested by the Subcommittee and carried out by

OFHEO should provide useful information about how the enterprises would

fare under the specified assumptions. However, we agree with OFHEO and

enterprise officials that the combined interest rate and credit stresses

specified by OFHEO in this analysis may differ from the statutory stress

tests mandated in the 1992 Act. Once the results of those tests are

available, OFHEO is to develop capital requirements that are consistent with

an acceptable level of taxpayer risk. OFHEO expects to complete its

proposed risk-based capital rule in Spring 1997.

(233505) Page 4 GAO/T-GGD-96-173
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