OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT

1700 G STREET, NW WASHINGTON, DC 20552 (202)-414-3800

June 15, 1997

Honorable Alfonse D’Amato Honorable Jim Leach

Chairman Chairman

Committee on Banking, Committee on Banking

 Housing, and Urban Affairs and Financial Services

United States Senate House of Representatives

Washington, D.C. 20510-6075 Washington, D.C. 20515-6050

Dear Chairmen:

I am pleased to transmit the fourth Annual Report to Congress of the Office

of Federal Housing Enterprise Oversight (OFHEO). This report has been prepared

to meet the statutory requirements in section 1319B of the Federal Housing

Enterprises Financial Safety and Soundness Act of 1992 (Title XIII of Pub. L. No.

102-550).

The views in this report are those of the Acting Director and do not

necessarily represent those of the President or the Secretary of Housing and Urban

Development.

Sincerely,

Mark Kinsey,

Acting Director
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I

Message from the Acting Director

“OFHEO protects the interests of the American taxpayer and contributes to the strength and

vitality of the nation’s housing finance system through independent, fair and effective financial regulation of Fannie Mae and Freddie Mac...”

This excerpt from OFHEO’s Mission Statement summarizes the fundamentals of OFHEO’s regulatory

assignment — taxpayer protection through independent safety and soundness oversight of Fannie Mae

and Freddie Mac. In the 12 months since OFHEO’s Director last reported to Congress, the Office has

worked diligently to carry out this mandate.

Much of OFHEO’s efforts in the past year have been focused on the technically complex interim steps

leading to publication of a proposed risk-based capital standard for Fannie Mae and Freddie Mac. Major

progress occurred in construction of the Financial Simulation Model that supports the stress test that

will be used to set risk-based capital levels. Various components of the FSM were completed in the past

12 months and the model is now in the testing phase. This is unheralded but critical work. OFHEO’s

team is moving expeditiously toward completion of the risk-based capital standard, but with the deliberation that this important task deserves. We remain committed to completing a proposed risk-based

capital regulation for the Enterprises in 1998.

In the examination area, OFHEO’s Office of Examination and Oversight conducted a series of examinations of the Enterprises in the past year. These included a business risk examination at Fannie Mae and

Freddie Mac and a data integrity examination at Freddie Mac. Results and conclusions of these and

other Enterprise examinations conducted by OFHEO are included in this report.

Also noteworthy in the past 12 months has been the broad professional acknowledgement, and wide-scale

publication, of OFHEO’s House Price Index. The HPI, published quarterly by OFHEO since the fourth

quarter of 1995, is now the most comprehensive statistical index generally available for use in tracking

changes in residential home values at the national, regional and state levels.

Financial regulation is not conducted in a vacuum. A summary of OFHEO’s recent activities must also

take into account the considerable time spent on communication with representatives of Fannie Mae and

Freddie Mac on a host of issues beyond day-to-day examination and financial oversight activities. These

issues included, but were not limited to, data confidentiality, charter interpretation, investment policies,

and consultation on new programs.
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OFHEO is a young organization, barely four years old. In this relatively brief time, the Office has

attracted a dedicated staff of talented professionals and managers. The exemplary work of these team

members, coupled with their continuing commitment to OFHEO’s regulatory mission, has been instrumental in OFHEO’s progress to date. Much of the credit for this initial team building and leadership

goes to OFHEO’s first Director, Aida Alvarez. In December 1996, President Clinton nominated Ms.

Alvarez to be Administrator of the U.S. Small Business Administration. Ms. Alvarez left OFHEO for

the SBA post in February.

OFHEO was created by Congress in 1992 to be an independent financial regulator protecting the

interests of the American taxpayer in a time of fast-moving economic and institutional change. In the

past five years, the pace and scope of change in the mortgage industry, OFHEO’s area of special interest,

has been especially rapid. This is due, in large measure, to technological innovation, standardization

requirements and new services introduced and promoted by Fannie Mae and Freddie Mac. The continued growth and influence of Fannie Mae and Freddie Mac in the mortgage industry, and in the capital

markets, only reemphasizes and reinforces the importance of OFHEO’s mission. I am confident that

OFHEO will continue to carry out its regulatory assignment with distinction.

Mark Kinsey

Acting Director

June 15, 1997
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III

In Memoriam

In her three years as Director of Examination and Oversight,

Marianne D. Wright left an indelible mark on OFHEO. Her professionalism, integrity and work ethic became the yardstick by

which we, her colleagues, measured our accomplishments. The

enthusiasm that she brought to her job was contagious. Her tenacity and humor in the face of illness was inspiring. As we mourn

her passing, Marianne Wright’s friends at OFHEO are profoundly

grateful for the time we shared with this cherished colleague.
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Table of Contents

Message from the Acting Director ............................................................................I

Chapter 1: The Price of a Mortgage ............................................................... 1

Introduction................................................................................................................ 1

What Is the “Price” of a Mortgage? ........................................................................... 1

The Components of Mortgage Price ......................................................................... 1

Interest Rate Risk

Credit Risk

Administrative Costs

Price and the Parties to the Mortgage Transaction ................................................... 3

Interest Rate Risk Pricing

Credit Risk Pricing

The Impact of Scoring Technology on Mortgage Pricing ........................................... 5

Chapter 2: Mortgage Markets and the Enterprises

 in 1996 and Early 1997........................................................................ 11

Housing and Primary Mortgage Market Developments........................................... 11

Housing Markets Were Strong

Loan Characteristics Reflected Market Conditions

Secondary Market Activities of the Enterprises ....................................................... 14

Purchases and Market Share Rose

1996 Purchases Appear to be Less Risky

New Issue Volumes of Securities Expanded, but Changes in Outstanding

 Volumes Were Relatively Small

Financial Condition of the Enterprises..................................................................... 17

Rapid Asset Growth Produced Higher Earnings

Debt Maturities Lengthened; Enterprises Re-enter Structured Note Market

Credit Indicators Were Stable

Enterprises Continue To Meet Capital Requirements
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V

Chapter 3: OFHEO’s Regulatory Activities ................................................ 25

Capital Classification and Regulation of Fannie Mae and

Freddie Mac ....................................................................................................... 25

Capital Classification and Minimum Capital ............................................................ 25

Risk-Based Capital .................................................................................................. 25

Development of the Risk-Based Capital Regulation ................................................ 26

Creating a New Regulatory Tool .............................................................................. 26

The Database

Financial Simulation Model

OFHEO’s House Price Index (HPI).......................................................................... 29

Rating Agency Review of the Enterprises ...................................................... 29

Enterprise Examination .................................................................................... 31

Data Integrity Examination ...................................................................................... 33

Objectives and Scope

Results and Conclusions

Business Risk Examination ..................................................................................... 34

Objectives

Scope

Results and Conclusions: Fannie Mae

Results and Conclusions: Freddie Mac

Information Systems and Technology (IT) Risk Examination .................................. 37

“Year 2000”

Executive Compensation Authority................................................................. 38

Activities .................................................................................................................. 39

OFHEO Finance and Adminstration ................................................................ 39

Historical Data Tables ................................................................................... 41

Appendix ....................................................................................................... 57

Federal Housing Enterprises Safety and Soundness Act of 1992

Office of Federal Housing Enterprise Oversight

OFHEO Senior Officials

Index of Tables, Boxes and Figures
OFHEO 1997 Report to Congress 1

The Price of a Mortgage

Introduction

The price of a mortgage -- the effective interest

rate to a borrower or the yield to an investor --

is critically affected by the need to compensate

for uncertainty. If mortgage industry participants knew if and when borrowers would

prepay or default, the price of a mortgage could

be reduced to a risk-free rate plus administrative costs. Borrower time spent rate-shopping

would be reduced enormously as would the

actual rate paid.

The riskless mortgage, however, is not in sight.

Lenders cannot reliably predict individual

borrower behavior any more than they can

accurately forecast factors such as interest

rates, house prices, employment levels, and

divorce rates that drive mortgage defaults and

prepayments. While most borrowers are aware

of the effect of interests rates on their mortgage rates, they are unaware of the process by

which uncertainties about defaults and prepayments also affect their borrowing costs.

This chapter discusses the components of

mortgage pricing and the changes that are

occurring in mortgage risk measurement and

administrative practices that could have a

major impact on mortgage pricing.

What Is the “Price” of a

Mortgage?

The mortgage transaction is essentially the

exchange of money today for a promise to pay

tomorrow. To the borrower, “price” refers to the

interest rate, up-front fees, and possible mortgage insurance premiums. To a mortgage

investor, price is the amount paid today for the

borrower’s promise of a series of future payments. The investor requires these payments

in compensation for the time value of money

and the investor’s estimate of risk. The uncertainty over whether and when a borrower will

prepay or default is the source of an investor’s

risk. Thus the parties to the transaction can

think of price as either the interest rate promised on future payments or the estimated cash

value of the promise today. They are two aspects of the same transaction. In this chapter,

“price” refers to both concepts.

The Components of

Mortgage Price

As a mortgage moves from origination to a sale

to a conduit, to a mortgage-backed security

(MBS), and to an ultimate sale to an investor,

various industry participants retain a portion

of the borrower’s payment to compensate them

for the portion of services they provide. In this

sense, the price of a mortgage is comprised of

the risk-free rate plus the sum of three elements.

n Interest rate risk premium. Compensation for uncertainty regarding whether

and when a borrower will prepay the

mortgage.

n Credit risk premium. Compensation

for the risk that a borrower will fail to

make payments.

n Administrative costs. The costs of

originating and servicing the mortgage

and any subsequent MBS over their

lifetimes.

The two risk components of a mortgage are

particularly difficult to price. They involve

estimating the probability and timing of pre-
2 OFHEO 1997 Report to Congress

payment (interest rate risk) and the probability

and timing of default and the severity of the

loss (credit risk).

Interest Rate Risk

Investors deal with one form of interest rate

risk on all fixed income investments: a change

in interest rates causes a change in the value of

their portfolios. Mortgage investors face the

additional risk that borrowers may decide at

any time to exercise their rights to pay off their

loan balances. Borrowers routinely exercise

this right, either because they sell the home or

because they refinance for any of a variety of

reasons, such as obtaining a lower interest rate

to reduce their monthly payment.

From the standpoint of investors, prepayment

rates are both volatile and pernicious. Over the

past six years, Fannie Mae and Freddie Mac

experienced annualized prepayment rates on

their portfolios as low as 10 percent and as

high as 38 percent. Borrowers tend to prepay

most when interest rates fall, reflecting the

value of refinancing at more attractive rates.

Investors are then required to reinvest those

funds in lower yielding instruments. When

market rates rise, borrowers prepay less frequently, leaving investors with relatively

lower-yielding holdings in a higher interest

rate environment. Investors are willing to

accept this interest rate risk by requiring an

extra yield spread over risk-free borrowing

rates.

Credit Risk

Credit risk on a mortgage is the risk of loss as

a result of default. Mortgage originators and

investors expect a small share of mortgages to

default, even in the absence of unusual economic stress. For example, in research to

develop its risk-based capital standard,

OFHEO found that the Enterprises’ portfolios,

which are the largest portfolios of mortgages in

the U.S., experienced an average 10-year

cumulative loss rate of 2.1 percent for 30-year,

fixed-rate loans originated between 1979 and

19851

. Severe economic stress can substantially

increase loss rates. In that same research,

OFHEO found that the loans purchased by the

Enterprises during the stressful period of 1983

to 1984 in Arkansas, Louisiana, Mississippi,

and Oklahoma experienced a corresponding

loss rate of 9.4 percent. The Enterprises, mortgage insurers, and other credit risk managers

are prepared to absorb such losses, but require

compensation for accepting that risk. Enterprise guarantee fees, mortgage insurance

premiums, and the credit enhancements (e.g.,

reserves to absorb losses) required by nationally recognized rating agencies must be sufficient to cover both expected and extreme credit

losses.

Administrative Costs

Historically, the process of originating a mortgage was paper-intensive and usually took

weeks to complete. As a result, the process

added significant costs and time delays to

obtaining a mortgage. With the advent of new

technology, mortgage industry participants are

increasingly taking advantage of automated

systems and advanced data communication

technology to reduce costs and save time.

New technology makes it cheaper to store and

use information. Data warehousing facilitates

use of data from several different sources, such

as loan application, a credit repository, and a

loan payment history file. Advanced prepayment models are being used by mortgage

servicers to manage their portfolios. Communication networks are being used to exchange

information between a company and its vendors. Technology is also changing the way

applications are being developed, with more

partnerships between technology experts and

mortgage industry experts. These issues were

more fully discussed in OFHEO’s 1995 and

1996 Annual Reports.2

 These systems have

proven their ability to deliver reduced transaction costs for mortgage origination, and further

savings are anticipated as the industry

reengineers its business processes to take

advantage of them.
OFHEO 1997 Report to Congress 3

Price and the Parties to the

Mortgage Transaction

In the simplest model for a mortgage transaction, a bank or thrift originates a mortgage and

retains it in its portfolio. In this case, the

lender performs all services associated with the

mortgage and absorbs all risk.

In the securitization model for a mortgage

transaction, the separate risk management and

administrative services are unbundled. This

model typically involves several players -- a

mortgage banker to originate and service the

loan, a conduit to assemble a large pool of loans

and issue and administer an MBS, one or more

parties to absorb credit risk, and an investor to

purchase and hold the security and absorb the

interest rate risk. This model permits each

player to compete to provide the services in

which it is most efficient or has other comparative advantages.

Table 1 lists the separate elements of price

and the typical parties in a securitization

transaction. It illustrates how the components

of price are established in the course of originating and securitizing pools of mortgages.

Interest Rate Risk Pricing

The price that investors require for the use of

their funds depends, in part, on how long those

funds will be encumbered. Historical data on

loan payoffs provide investors with information

about past borrower prepayment behavior.

Securitization greatly facilitates analysis by

aggregating large numbers of mortgages from

widely diversified geographic locations into

pools with common characteristics. The result

is relatively homogeneous mortgage pools,

whose prepayment behavior can be analyzed by

market participants.

Using models that estimate prepayment speeds

under a variety of future interest rate paths,

Table 1

How Prices Are Established in a Securitization Model

Investors bidding for mortgage

securities in an auction market.

The Enterprises negotiate guarantee fees at mortgage purchase.

Mortgage insurers bidding for

business from mortgage originators.

Private conduits must provide

sufficient enhancement to achieve

an investor quality rating (triple-B or

better) from a nationally recognized

rating agency.

Loan originators and servicers;

origination points are commonly a

basis for competition among originators and negotiation with borrowers.

Investor (or dealer) interest

rate risk simulation models.

Enterprise credit risk

simulation models.

Mortgage insurer credit risk

simulation models.

Rating agency credit risk

simulation models.

Originator marketing decisions,

as affected by Enterprise and

conduit requirements and

accounting standards.

Risk-free rate + premium

for interest rate risk

Guarantee fee

Mortgage insurance

premium

Other credit enhancement

costs (subordination, pool

insurance, recourse,

spread accounts, etc.)

Origination and servicing

fees (including administration, sales, pipeline risk

management, etc.)

Time Value of

Money &

Interest Rate

Risk

Credit Risk

Administrative

Costs

Cost

Elements

Transaction Item Representative Parties and

Transaction

Analytic Criteria
4 OFHEO 1997 Report to Congress

analysts compute the interest rate risk premium implicit in market prices. Of course,

different models can, and do, yield different

results. Nonetheless, they provide a commonly

accepted structure for investor decision-making

and reporting. Actual prices are not set by

modeling, but rather are the product of a

bidding process. Participants in the bidding use

their models to inform their bids.

Credit Risk Pricing

The managers of mortgage credit risk use

statistical analysis of historical mortgage

performance to predict credit losses on mortgage portfolios. Until recently, mortgage credit

research analyzed the relationship between

mortgage performance and the information

captured in the traditional loan underwriting

process. Now the industry is increasingly using

consumer credit scores and mortgage scores to

enhance its ability to predict credit losses.

Industry participants are adjusting their

origination and pricing systems and practices

to take advantage of the improved risk measurement provided by this type of quantitative

scoring.

The mortgage market uses three basic pricing

mechanisms to provide credit risk protection.

These are guarantee fees, mortgage insurance

premiums, and credit enhancement costs.

Guarantee fees on MBS and mortgage insurance premiums are used to compensate the

Enterprises or the mortgage insurance companies for any default on a loan that is insured or

guaranteed by them. A credit enhancement is

available to pay for any default in the pool of

loans to which it applies.

Enterprise Guarantee Fees

Fannie Mae and Freddie Mac retain a portion

of the borrower payments as a fee for guaranteeing to the investor the timely payment of

interest and principal. Most of the guarantee

fee covers credit risk. The Enterprises calculate

the default cost components of their guarantee

fees by analyzing their historical loss experience and by using models to simulate future

loan performance. The Enterprises negotiate

with lenders guarantee fees that reflect the

historical performance of the loans purchased

previously from that lender. In 1996, Fannie

Mae earned an average guarantee fee of 0.224

percent, and Freddie Mac earned an average

guarantee fee of 0.234 percent.

Mortgage Insurance

Credit risk on high loan-to-value (LTV) mortgages is generally shared with mortgage insurers. Mortgage insurers take the “first loss

position” by absorbing losses up to the coverage

ratio, which is a stated percentage of the outstanding loan. The Enterprises have established mandatory levels of mortgage insurance

in their underwriting guidelines, depending on

the risk they perceive in certain categories of

mortgages. The non-conforming mortgage

market3

 has adopted similar practices.

Mortgage insurance companies establish prices

for the different amounts of credit loss coverage

they provide. Mortgage insurance prices are

risk-based, in that they vary not only with the

amount of coverage, but also with the probability that loss will occur. LTV ratios are typically

used as indicators of credit risk and influence

price in two ways:

n There is a higher probability of default

on high LTV loans than on low LTV

loans.

n High LTV ratios reduce the amount of

borrower equity, which increases the

amount of potential loss to the insurer in

the event the loan defaults.

For example, as shown in Table 2, the Enterprises’ requirement of 25 percent coverage on a

90 percent loan would cost 0.52 percent. The

same coverage on a more risky 95 percent loan

(which might be acceptable for a non Enterprise loan) has a higher cost of 0.67 percent

(see highlighted rows in Table 2).

Private Conduit Credit Enhancements

Private conduits securitize mortgages that the

Enterprises cannot purchase due to statutory
OFHEO 1997 Report to Congress 5

limits on loan size or will not purchase due to

underwriting standards. Since they lack the

capital and corporate credit ratings necessary

to provide effective guarantees of their MBS,

private conduits arrange credit enhancements

to protect investors from credit losses.

The prevailing form of credit enhancement

today is subordination. This is accomplished by

creating one or more “subordinate classes” of

securities that receive payment only after all

payments have been made on the senior

classes. They thereby absorb losses from the

pool. The credit risk price is expressed as a

required level of subordination. Typical levels

of subordination are 5-10 percent of the total

security balance.

Nationally recognized credit rating agencies

analyze individual conduit pools and establish

levels of credit enhancement required to receive a particular rating for a security. The

highest grade (triple-A) requires the largest

amount of credit enhancement and is viewed by

investors as closest in credit quality to Enterprise securities. The top four grades (triple-A

through triple-B) are “investment grade”,

which is acceptable to more investors than

lower grades.

The Impact of Scoring

Technology on Mortgage Pricing

Changes in mortgage prices are possible because of better information about mortgage

risks and lower cost ways of doing business.

Credit scoring, mortgage scoring, and automated underwriting systems (scoring technology) are changing the way that credit risk is

measured. Mortgage insurance companies, the

rating agencies, and the Enterprises are incorporating this scoring technology into their

business activities, and they are encouraging

their respective customers to do so as well.

Changes in measuring credit risk are being

reflected in how mortgages are priced in the

non-conforming market and may soon be

reflected in the conforming market, since credit

risk is an important component of mortgage

price.

The mortgage industry’s estimate of credit risk

is already changing for particular loans. Table

3 displays part of Duff & Phelps’ approach to

rating mortgage pools. The rating process

establishes the level of credit enhancement

needed in order to achieve a particular rating

for a security. The credit enhancement must

cover the expected losses, as estimated by a

simulation model. The higher the rating for the

security, the greater the degree of economic

stress the pool can withstand without producing losses for the investor. The higher rating,

therefore, requires a higher level of credit

enhancement.

The table illustrates the effect of incorporating

mortgage scores into the rating process. The

credit enhancement requirements when not

Table 2

Sample Mortgage Insurance

 Rate Sheet

* Unpaid Principal Balance

97 40 1.19

97 35 1.04

97 30 0.90

97 28 0.85

97 25 0.77

95 35 0.90

95 30 0.78

95 27 0.71

95 25 0.67

95 22 0.63

90 35 0.67

90 30 0.60

90 25 0.52

90 20 0.42

90 17 0.39

90 12 0.34

85 30 0.52

85 25 0.43

85 20 0.39

85 17 0.37

85 12 0.32

85 6 0.26

Annual

Premium

(% UPB)

Original LTV

(% Value)

Percent

Coverage

(% UPB*)

Source: PMI Mortgage Insurance Co., 11/15/96 Rate

Sheets.
6 OFHEO 1997 Report to Congress

using mortgage scores are displayed in the

fourth column. Columns 5, 6, and 7 show the

credit enhancement requirements when using

mortgage scores. Based on the simulation run

for the stress level associated with a AAA

rating, Duff & Phelps estimated that 85 percent LTV mortgages would experience a 19.8

percent cumulative default rate, with loss

severity of 48.4 percent of the pool balance,

resulting in a loss of 9.57 percent (0.198 x

0.484) of the original pool balance. Therefore,

the required credit enhancement would be 9.57

percent of the pool.

Duff & Phelps then adjusted the credit enhancement requirements based on its evaluation of the particular mortgage scoring system

and its interaction with the risk estimates in

its loss simulation model. Duff and Phelps

divided the loans into low risk, moderate risk,

and high risk categories, based on mortgage

scores. For the same AAA rating on 85 percent

LTV mortgages, the credit enhancement requirement would be only 7.18 percent if the

loans were low risk. If the loans were high risk,

the credit enhancement requirement would go

up to 9.28 percent.

The rating agency example highlights two

potential benefits of improved credit risk

measurement techniques. First, the credit

enhancement requirement might be reduced

for particular loans. In this case, the requirement for 85 percent LTV loans is lower when it

is known that the mortgage scores are high

(credit risk is low). Second, the credit enhancement requirement might be reduced even for

high risk loans. In this case, the high risk 85

percent LTV mortgages would require credit

enhancement of 9.28 percent rather than 9.57

percent if the mortgage score were unknown.

This suggests that there is a cost savings

associated with better information.

These two features of improved risk measurement hold the potential for overall reductions

in credit risk costs, and resulting reductions in

mortgage interest rates. The impact may be

strongest where risk measurement is most

uncertain. In subprime mortgage markets,

credit risk costs -- and mortgage interest rates

-- are substantially higher (see Box 1 on page

9 for further discussion of the subprime

market.)

In another application of scoring technology

Standard & Poor’s (S&P), has developed a new

system for categorizing risk. Based on extensive research conducted with Fair Isaac Co.

Inc. (FICO) and Freddie Mac, using Freddie

Mac’s Loan Prospector mortgage scoring system, S&P revised its rating practices to rely

Mortgage Score Risk Rating

Rating LTV Rate

(2)

CE*

(4)

Source: Duff & Phelps Credit Rating, Co., “Credit Scoring: A DCR Primer”, March 1997. Sample mortgages are 30-year fixed

rate underwritten to the Enterprises full documentation guidelines, varying only by LTV.

Table 3

The Impact of Credit Scores on Risk Rating

(In Percent)

65

75

85

65

75

85

Severity

(3)

Low Risk CE*

(5)

High Risk CE*

(7)

Mod. Risk CE*

(6)

Without Mortgage Score

 Risk Rating

AAA

BBB

6.1

11.3

19.8

1.3

3.3

7.3

29.9

40.4

48.4

12.5

15.7

25.2

1.83

4.54

9.57

0.16

0.51

1.84

1.65

3.64

7.18

0.12

0.38

1.29

1.83

4.41

8.61

0.15

0.46

1.57

2.29

4.54

9.28

0.20

0.51

1.79

* Credit Enhancement

(1)
OFHEO 1997 Report to Congress 7

very heavily on credit and mortgage scoring.

S&P now uses seven risk grades for mortgages

rather than the A, A-, B, C, and D scale which

is based on traditional underwriting guidelines. Where mortgage scores are available,

they are used to determine risk grades. If only

the FICO credit score is available, S&P applies

its own methodology to generate a mortgage

score and risk grade. Only where neither score

is available does S&P revert to grades based on

traditional underwriting guidelines. At this

writing, S&P has accepted several additional

mortgage scoring systems for use as the basis

for its risk grades.

Table 4 displays S&P’s description of its risk

grading system, and the relative credit enhancement requirements associated with the

risk grades. The amount of credit enhancement

required for Superior loans (RG1) is 20 percent

below that required for average loans (RG3).

The requirement for loans with the highest risk

of default (RG7) is four times that required for

average loans.

The impact of scoring technology on borrowers

is hard to predict. At a minimum, borrowers

can expect that their credit score will be part of

the information used to review their application. The likelihood that a mortgage score will

be generated is steadily rising. To date, this

scoring information generally has not been

used to price their loans. However, as more

industry participants use scoring technology, it

seems inevitable that risk-based pricing will

move to the primary market.

One result of these developments will be a less

onerous and paper-intensive mortgage application process. Because mortgage scores are

designed to capture borrower characteristics

that are most predictive of loan performance,

additional information that has marginal value

will no longer need to be provided. This is most

true for applicants with high mortgage scores.

Lenders will still request documentation to

help underwriters judge applications that are

not easily approved by an automated system.

Table 4

Standard & Poor’s Risk Grades

RG1

RG2

RG3

RG4

RG5

RG6

RG7

Superior Quality - Loans Exhibiting Lowest Default Potential

Above Average Quality - Expected To Outperform The Market

Overall

Average Quality Loans - Exhibit Default Rates Generally Expected

Of Loans Underwritten To Guidelines

Slightly Below The Quality Exhibited By Agency Underwriting

Loans Exhibiting Default Expectations Considerably Higher Than

Average Loans

Loans With Default Rates At Significant Multiples Of The Average

Quality Loans

Loan Exhibiting The Highest Risk Of Default

0.80

0.90

1.00

1.25

2.00

3.00

4.00

Grade Description

Credit

Enhancement

Factor

Source: Standard & Poor’s, “Automated Underwriting & Mortgage Score Applications”, presented to the MBA National Secondary

Market Conference, May 5, 1997.
8 OFHEO 1997 Report to Congress

1

 61 Federal Register 29592, June 11, 1996.

2

 OFHEO 1995 Annual Report to Congress, Chapter 1 - Current Issues. OFHEO 1996 Annual Report to Congress, Chapter 1 - Major

Trends in Single-Family Mortgage Lending and Chapter 2 - Use of Scoring in Mortgage Lending. 3

 The sizes of mortgage loans that the Enterprises are permitted to buy are limited by their Charter Acts. These limits are usually

referred to as “conforming loan limits”. For example, the maximum original principal amount of a single-family mortgage that

the Enterprises can buy is $214,600. In addition to loan size, conforming loans must also meet the Enterprises’ underwriting

guidelines. Non-conforming loans are loans that either exceed the conforming loan limits or do not meet the Enterprises’

underwriting guidelines. Non-conforming loans that exceed $214,600 are often called “jumbo” loans.

Despite the potential cost savings, mortgage

lenders are proceeding cautiously because of

up-front costs associated with implementing

new technology, changing lending policies and

procedures, and training originators to work

with applicants. Lenders realize that to use the

technology effectively, they must rethink their

business processes. Also there are potential

hazards in working with borrowers who are not

familiar with credit scores or mortgage scores

and do not have access to their own score. An

applicant may be denied a loan because of some

information that the lender obtained, generated by a computer model without the

applicant’s knowledge, and that the applicant

does not understand. Also an applicant may be

denied by one lender but approved by another

lender who obtains a credit score from a different source that uses somewhat different information, as can happen with credit repositories.

Finally, risk-scoring has yet to be proven

effective in predicting loan performance in a

period of severe economic distress. Risk scores,

by definition, predict the expected performance

of future loans based on the performance of

past loans of similar characteristics. All of the

loans used to build today’s risk scores were

originated in fairly good economic times.

OFHEO intends to monitor the performance of

loans purchased by Fannie Mae and Freddie

Mac which use their scoring technology.
OFHEO 1997 Report to Congress 9

Box 1

Subprime Markets and the Blurring of the Conforming Market

The subprime market encompasses a wide range of mortgage products, including mortgage loans to borrowers with

imperfect credit histories; several forms of second mortgages, including both closed and open-ended home equity

loans; and even so-called “125 percent LTV” loans where the total indebtedness exceeds the estimated home value.

Investors have shown increasing interest in this market. For example, total issuance of home equity loan securities

rose to a near record $10.8 billion for the first quarter of 1997. Subprime mortgage loans accounted for 78 percent of

this volume (April 11, 1997, Inside MBS & ABS).

Mortgage pricing in subprime markets includes a premium over prime market rates that varies with the weakness in

a borrower’s credit profile and other loan risk indicators. Mortgage terms are similarly restrictive, with relatively low

LTV loans the rule. Borrowers face severe information shortages in evaluating offers, since it is difficult to find “standard rates” on subprime loans.

Freddie Mac delivers S&P credit enhancement requirements on these loans as part of its Loan Prospector automated underwriting system. Fannie Mae has announced plans to add similar capabilities to Desktop Underwriter. As

a result, subprime lenders have increasing access to the information they need to establish competitive prices with

confidence that investors will be prepared to buy the resulting securities.

Systems like Loan Prospector which are used to underwrite subprime mortgages permit originators to recognize

loans that qualify for purchase by the Enterprises, moving them out of the subprime market and increasing the size

of the prime market. Originators of these loans will be able to form Enterprise MBS which trade at higher prices than

other MBS. Continued testing of their scoring models and expansion of their databases permit the Enterprises and

other scoring developers to improve their measurement of the credit risk of these loans.

The application of improved risk measurement techniques to manually underwritten pools illustrates the potential

impact. S&P applied automated scoring to a traditionally underwritten pool of subprime mortgages with striking

results (see figure below). While traditional underwriting tended to bunch the loans into the lowest grades (“C” and

“D”), the automated system with mortgage scoring placed many more loans into the “A” credit categories. Overall risk

estimates for the pool were distinctly lower. More than one-third of the loans previously classified as subprime moved

into the “A” grades under automated underwriting.

0%

5%

10%

15%

20%

25%

30%

35%

A+ A A- B C D

Manual

Automated

Calculated from Standard & Poors, “Innovations in Mortgage

Risk Measurement”, January 1997.

Comparison of Automated and Manual

Underwriting on a Subprime Pool
OFHEO 1997 Report to Congress 11

Fannie Mae and Freddie Mac maintained

double-digit growth in profits in 1996 and early

1997 on the strength of recent rapid increases

in their holdings of mortgages and their own

mortgage securities, consistent with the pattern of recent years. Net interest income now

accounts for more than two-thirds of the Enterprises’ combined gross revenues. New mortgage purchase and guarantee volumes for the

Enterprises rose last year to their highest

levels since 1993, as the nation’s strong

economy and low interest rates stimulated

record house sales and increased refinancing of

existing loans. While the Enterprises’ market

share of new loans also rose, largely because of

decreased borrower interest in adjustable-rate

loans, it remained below the level of the early

1990s.

Combined capital of Fannie Mae and Freddie

Mac rose $2.7 billion, more than sufficient to

enable each Enterprise to meet its minimum

capital requirement. The additional capital

provided protection against increases in both

interest rate and credit risks. The Enterprises

continued to fund mortgage asset acquisitions

with large volumes of long-term callable debt,

which limits loss exposure from possible future

interest rate changes. They also increased the

average effective maturities of their debt to

offset a lengthening in expected asset lives as

interest rates rose, on balance, during the year.

Credit risk indicators were generally stable

last year. New loans had slightly better risk

characteristics than those of the previous two

years. Multifamily delinquencies declined

sharply, benefiting from stronger markets, but

the Enterprises’ single-family delinquencies

were little changed, despite significant improvement in the market as a whole.

Housing and Primary Mortgage

Market Developments

Housing Markets Were Strong

A strong economy and low financing costs set

the tone for 1996 and early 1997 in housing

and mortgage markets. The economy grew by

more than 3 percent last year, driving the

unemployment rate down to its lowest level in

seven years, and consumer confidence to its

highest level over the same period. Mortgage

interest rates in 1996 were, on average, lower

than a year earlier (see Figure 1). Lender

commitment rates on 30-year, fixed-rate mortgages (FRMs) declined to 7 percent early in the

year, approaching their 1993 lows. Rates rose

1.3 percentage points by mid-year before declining to a narrow range of 7.6 to 7.9 percent

late last year and early this year. Initial rates

on adjustable-rate mortgages (ARMs) followed

a similar pattern, but rose and fell by smaller

amounts.

Mortgage Markets and the

Enterprises in 1996 and Early 1997

Figure 1

Mortgage Interest Rates

Source: Freddie Mac

0%

2%

4%

6%

8%

10%

Jan-91Jan-92Jan-93Jan-94Jan-95Jan-96Jan-97

30-Year FRM Rate

1-Year ARM Rate
12 OFHEO 1997 Report to Congress

Under these conditions, markets for both new

and existing homes were strong. Housing

starts rose to a 9-year high in 1996, and sales

of single-family homes were close to their 1978

record levels. Multifamily starts rose 14 percent last year, but remained well below their

levels throughout the 1980s. The pace of starts

and sales continued at similar rates in early

1997.

Single-family house prices, as measured by

OFHEO’s House Price Index, rose nearly 3.5

percent in 1996 (see Figure 2), slightly faster

then the general inflation rate, as measured by

the consumer price index, of 3.3 percent. That

was slower than in 1995 but considerably

faster than in the early 1990s. In general,

house prices rose more rapidly in the interior of

the country and less rapidly on the Pacific and

Atlantic coasts (see Figure 3).

Figure 3

One Year Change in House Prices

U.S. Census Divisions

Fourth Quarter 1995 to Fourth Quarter 1996

Source: OFHEO House Price Index

CA

WA

NV

OR

ID

AZ

UT CO

NM

AR

T N

NJ

 CT

DE

RI

DC

 

HI T X 

L A 

ND

S D 

NE 

KS

OK 

 MO 

IA 

 MN 

 WI 

IN 

 PA 

 NY 

 ME 

IL

MS

AK

MT VT

 NH

WY 

AL

 MD

Eas t

S outh

Centr al

Pacific

New England

Eas t MA

Nor th

Centr al

Wes t Nor th

Centr al

Mountain

Wes t S outh Centr al

MS

T N

KY

PA

ME

OH

IL IN

WI

 MI

NY

PA

S outh Atlantic

 FL

GA

S C

NC

VA

WV

NY

CA

Middle Atlantic

6.5%

5.7%

5.7% 1.2%

2.3%

1.1%

2.9%

2.2%

5.1%

Figure 2

OFHEO House Price Index (United States)

Annual Percent Changes

Source: OFHEO House Price Index

0%

2%

4%

6%

8%

10%

19821984198619881990199219941996
OFHEO 1997 Report to Congress 13

Mortgage originations increased 23 percent last

year to $785 billion (see Figure 4). Purchase

money mortgage volumes benefited from the

increased pace of house sales. At the same

time, the low interest rates and firmer house

prices that stimulated mortgage demand to

finance increased home sales, also spurred

refinancings of existing loans (see Figure 5).

There were two periods of notable refinancing

volumes -- one at the beginning of the year,

which extended a small refinancing boom from

late 1995, and the other at the end of the year,

coinciding with the lower interest rate periods.

Volumes were considerably higher during the

first period because interest rates were lower.

Loan Characteristics Reflected

Market Conditions

The composition of conventional loan originations in 1996 reflected the interest rate environment. The share of ARMs ranged from 14 to

36 percent, with higher shares occurring in the

summer, when rates on fixed-rate loans rose

both in absolute terms and relative to ARMs

(see Figure 6). For 1996 as a whole, the ARM

share fell to an average of 27 percent from 33

percent in 1995, when relatively high yields on

fixed-rate loans early in the year encouraged a

much higher proportion of borrowers to choose

ARMs.

The share of 15-year fixed-rate loans rose only

marginally, notwithstanding higher refinancing activity that has stimulated large increases

in the volume of these loans in the past. At

current rates, payments on 15-year loans are

roughly one-fourth higher than payments on

30-year loans, despite their lower interest cost

of about one half percentage point. Payments

on 15-year loans are unlikely to become more

attractive to borrowers without a significant

decline in interest rates or steepening of the

yield curve -- conditions experienced in 1992

and 1993.

The average loan-to-value (LTV) ratio on new

conventional mortgages, as measured by the

Federal Housing Finance Board, fell to 79

percent. This was largely due to the higher

share of refinanced loans, which generally have

lower LTV rates. Nonetheless, the average

borrower downpayment in 1996 remained

significantly lower than in 1990 and 1991,

despite refinancing shares in those years that

were as high or higher.

The distribution of originations by lender type

showed, for the most part, a continuation of

Figure 4

Originations of Single-Family Mortgages

($ in Billions)

Source: HUD

$0

$200

$400

$600

$800

$1,000

$1,200

19861987198819891990199119921993199419951996

FHA/VA Conventional Total

Figure 5

Refinance Share of Total Mortgage

Originations vs. Commitment Rate on

30-Year FRMs

Source: Freddie Mac

0%

4%

8%

12%

16%

Jan-91Jan-92Jan-93Jan-94Jan-95Jan-96Jan-97

0%

20%

40%

60%

80%

30-Year FRM Rate

Refinance Share

30-Yr 

FRM Rate

Refinance 

Share
14 OFHEO 1997 Report to Congress

recent trends (see Figure 7). The origination

share of mortgage companies rose for the sixth

straight year, to 57 percent while the share for

commercial banks fell to 23 percent. The thrift

institutions’ share rose slightly to 20 percent,

the first rise in eight years, following the

industry’s severe shrinkages in the early

1990s.

Secondary Market Activities of

the Enterprises

Purchases and Market Share Rose

Purchases and new guarantees by Fannie Mae

and Freddie Mac of single-family mortgages

(excluding purchases of their own guaranteed

securities) rose by more than 30 percent for

each Enterprise in 1996 (see Figure 8).

During the first quarter of 1997, Enterprise

purchases and guarantees rose slightly, owing

to greater refinancing volumes, but remained

well below the pace of early 1996.

Last year’s increase in Enterprise purchases

and guarantees substantially exceeded the 20

percent increase in conventional mortgage

originations. This stemmed largely from a

lower origination share of ARMs, which are

more frequently retained in lender portfolios.

As a result, Enterprise market shares of new

conventional single-family mortgages rose (see

Figure 9). Market share soared in the 1980s

with the development of the mortgage securities market, and rose further in the early 1990s

as depository institutions struggled to re0%

20%

40%

60%

80%

100%

197219761980198419881992

1996*

Commercial Banks

Thrift Institutions

Mortgage Companies

Other Lenders

Figure 8

Enterprises’ Single-Family Mortgage

Purchases ($ in Billions)

$289

$217

$283

$519

$440

$233

$185

$0

$100

$200

$300

$400

$500

$600

1990199119921993199419951996

Freddie Mac Fannie Mae Combined

Source: Fannie Mae and Freddie Mac

Figure 7

Single-Family Originations by Lender

Source: HUD

*Estimated

Figure 6

ARM Share of Conventional Single-Family

Loans vs. Commitment Rate on 30-Year FRMs

Source: Freddie Mac and Federal Housing Finance Board

0%

4%

8%

12%

16%

Jan-91Jan-92Jan-93Jan-94Jan-95Jan-96Jan-97

0%

20%

40%

60%

80%

30-Year FRM Rate

ARM Share

30-Yr

FRM Rate

ARM 

Share
OFHEO 1997 Report to Congress 15

age LTV ratios declined marginally for the first

time in several years. Significantly, the portion

of new loans with LTVs greater than 90 percent, which have much higher than average

risk, declined at Fannie Mae and leveled

off at Freddie Mac from 1995 to 1996 (see

Figure 10). The Enterprises’ proportion of

higher LTV loans remained substantially less

than that of all conventional market originations.

The mix of single-family loan types purchased

or guaranteed by the Enterprises also was less

risky. The share of ARMs was lower. These

loans may subject borrowers to substantial

payment increases if interest rates rise. At the

same time, the share of intermediate-term

loans was slightly higher. These loans amortize

more rapidly, reducing the likelihood that the

collateral would be insufficient to cover the

loan balance in the event of default.

Enterprise purchases and new guarantees of

multifamily mortgages also rose sharply last

year to more than $9 billion (see Figure 11).

Volumes have more than tripled over the past

four years, reflecting large increases at both

Enterprises. Because multifamily mortgages

establish stronger capital ratios. In the past

three years, Fannie Mae and Freddie Mac’s

market share has retreated to an average of 41

percent, about the same as their share of

outstanding conventional loans.

As other financial institutions look for new

ways to compete with the Enterprises, Fannie

Mae and Freddie Mac may find it difficult to

increase their market share of their traditional

business. Last year, the Federal Home Loan

Bank of Chicago announced a pilot program

that would allow member banks and thrifts to

retain most of the credit risk, and receive

favorable capital treatment, on new loans.

Interest rate risk would shift to the Home Loan

Bank. Such a program, if implemented on a

large scale, could create a significant new

source of competition for the Enterprises.

1996 Purchases Appear to

Be Less Risky

Changes in the composition of the Enterprises’

new credit risks reflected changes in the primary market. In general, risk characteristics of

1996 loans appear to be slightly better than

those purchased or guaranteed in 1995. AverSource: Fannie Mae, Freddie Mac, and Federal Reserve Board

Figure 9

Enterprises’ Share of Conventional

Single-Family Mortgage Market

0%

10%

20%

30%

40%

50%

60%

1990199119921993199419951996

Purchases/Originations

Share of Outstandings

Source: Fannie Mae, Freddie Mac, and Federal Housing

 Finance Board

0%

10%

20%

30%

19921993199419951996

L T V > 90%

Fannie Mae Freddie Mac Conventional Originations

Figure 10

Proportion of Single-Family Mortgage

Purchases with LTV Ratios Greater than 90%
16 OFHEO 1997 Report to Congress

issues. These purchases represented more than

one-quarter of last year’s new issue volume in

both cases. Each Enterprise now holds close to

15 percent of its own securities. As a result, the

outstanding volume of securitized mortgages in

the hands of other investors increased at a

slower rate -- 7 percent for Fannie Mae and 3

percent for Freddie Mac -- to a combined total

of more than $1 trillion. The different rates of

growth partly reflected a faster pace of liquidation of Freddie Mac mortgages. A contributing

factor is that Freddie Mac’s securities include a

higher portion of adjustable-rate and balloon

loans, which were more likely to prepay as

borrowers sought to lock in last year’s low

interest rates.

New Real Estate Mortgage Investment Conduit

(REMIC) issuances more than doubled to $34

billion at Freddie Mac, and more than tripled

to $27 billion at Fannie Mae (see Figure 13).

A steeper yield curve and market demand for

new REMIC structures were mainly responsible for the increases. Despite the volume

jumps, last year’s totals amounted to less than

one-fifth of 1993’s peak volume. New issues

were insufficient to offset liquidations of the

underlying loans, as outstanding REMIC

volumes fell for the third consecutive year to a

are relatively risky, the increase in originations

of these loans offsets somewhat the decrease in

risk for single-family purchases.

New Issue Volumes of Securities

Expanded, But Changes in Outstanding

Volumes Were Relatively Small

In 1996, more than 90 percent of Fannie Mae

and Freddie Mac’s mortgage purchases were

securitized. Accordingly, volumes of new issuances of single-class mortgage-backed securities (MBS) closely followed the Enterprises’

purchase volumes (see Figure 12). While

Freddie Mac’s securitization percentage has

historically been over 90 percent, Fannie Mae’s

averaged 73 percent before rising over the past

two years to 86 percent. The increase in the

proportion of securitized purchases reflects, in

part, increased lender preference for an

exchange of MBS for loans instead of cash.

Both Enterprises are becoming increasingly

significant investors in their own securities,

which has moderated growth rates of nonEnterprise investor holdings. Last year, Fannie

Mae purchased $45 billion of its MBS issues

and Freddie Mac purchased $32 billion of its

$9

$7

$5 $4

$3 $3

$5

$0

$1

$2

$3

$4

$5

$6

$7

$8

$9

1990199119921993199419951996

Freddie Mac Fannie Mae Combined

Figure 11

Enterprises’ Multifamily Mortgage Purchases

($ in Billions)

Source: Fannie Mae and Freddie Mac

Figure 12

Enterprise Single-Class MBS Issuance

($ in Billions)

$171

$205

$373

$430

$248

$270

$196

$0

$50

$100

$150

$200

$250

$300

$350

$400

$450

1990199119921993199419951996

Freddie Mac Fannie Mae Combined

Source: Fannie Mae and Freddie Mac
OFHEO 1997 Report to Congress 17

combined total of $521 billion. Issuance volumes continued to increase in early 1997,

implying increasing investor interest in these

securities.

Financial Condition of the

Enterprises

Rapid Asset Growth Produced

Higher Earnings

Combined profit of the Enterprises was just

short of $4 billion (see Tables A and B on

pages 18-19 for selected financial data).

Freddie Mac’s 1996 net income grew 14 percent. Fannie Mae’s net income grew 15 percent

after adjusting for its 1995 contributions to the

Fannie Mae Foundation. These growth rates

were both somewhat higher than in the previous year. Growth continued in early 1997;

Freddie Mac’s first quarter income was 10

percent above the comparable 1996 quarter,

and Fannie Mae’s income rose 14 percent over

the year-ago quarter.

Revenue growth supporting the higher earnings of the Enterprises differed greatly between

the Enterprises’ two principal lines of business:

portfolio investments and mortgage credit

guarantees. Of the two revenue sources, spread

income on investments continued to drive

overall revenue growth, as it has done consistently in recent years (see Figure 14). The

bulk of the Enterprises’ investments, and the

most profitable portion, is comprised of mortgages and mortgage securities. Taken together,

the Enterprises have added more than $100

billion of mortgage assets since 1994, a 44

percent increase. In 1996, Freddie Mac’s net

interest income grew 22 percent and contributed 94 percent of revenue gains. At Fannie

Mae, net interest income rose 18 percent from

a much smaller base and accounted for 81

percent of all revenue growth. (Freddie Mac’s

figures on net interest income are adjusted

from its reported numbers to include guarantee

fees on portfolio holdings of its own MBS. This

adjustment makes the data comparable to

Fannie Mae’s.)

Interest earnings at both Enterprises were

significantly affected by the refunding of previous debt issues. Fannie Mae was able to call

substantial amounts of debt with high yields,

which were replaced more cheaply. While

Freddie Mac was also able to call some higher

yielding debt, that benefit was more than offset

Figure 13

Enterprise REMIC Issuances

Source: Fannie Mae and Freddie Mac

$61

$24

$129

$311

$286

$174

$101

$0

$50

$100

$150

$200

$250

$300

$350

1990199119921993199419951996

Freddie Mac Fannie Mae Combined

Figure 14

Enterprises’ Primary Sources of Revenue

($ in Billions)

$0

$1

$2

$3

$4

$5

$6

19921993199419951996

Net Interest Income Guarantee Fees

Source: Fannie Mae and Freddie Mac
18 OFHEO 1997 Report to Congress

FANNIE MAE

 SELECTED FINANCIAL HIGHLIGHTS

(Dollars in Billions)

1997Q1

Annualized

1996 1995 1994 1993

EARNINGS PERFORMANCE:

 Earnings ($) 2.94 2.72 2.14 2.13 1.87

 Net Interest Income ($) 3.80 3.59 3.05 2.82 2.53

 Guarantee Fees ($) 1.25 1.20 1.09 1.08 0.96

 Net Interest Margin (%)1 1.17 1.18 1.16 1.24 1.38

 Average Guarantee Fee (bp)2 22.7 22.4 22.0 22.5 21.3

 Return on Common Equity (%) 24.0 24.1 20.9 24.3 25.3

 Dividend Payout Ratio (%)3 32.6 31.4 34.6 30.8 26.8

BALANCE SHEET POSITION:

 Total Assets ($) 357.0 351.0 316.5 272.5 217.0

 Outstanding Debt ($) 336.2 331.3 299.2 257.2 201.1

Mortgages:

 Retained Mtge. Portfolio ($) 291.7 286.5 252.9 220.8 190.2

 MBS (excl. MBS in Portfolio) ($) 554.1 548.2 513.2 486.3 471.3

 Retained as % of Total Mtgs.

 in Portfolio and MBS (%) 34.5 34.3 33.0 31.2 28.8

Capital:

 Equity/Assets & MBS (%) 1.45 1.42 1.32 1.26 1.17

 Equity & Reserves/

 Assets & MBS (%)4 1.53 1.50 1.41 1.37 1.29

 Source: Fannie Mae

 1. Taxable equivalent net interest income divided by average earning assets.

 2. Guarantee fees divided by average MBS outstanding net of MBS held in portfolio.

 3. Common and preferred dividends divided by net income.

 4. Effective 1/1/95, reserves exclude valuation allowance related to impaired loans pursuant to SFAS 114.

Table A
OFHEO 1997 Report to Congress 19

FREDDIE MAC

 SELECTED FINANCIAL HIGHLIGHTS

(Dollars in Billions)

1997Q1

Annualized

1996 1995 1994 1993

 EARNINGS PERFORMANCE:

 Earnings ($) 1.32 1.24 1.09 0.98 0.79

 Net Interest Income ($)1 1.93 1.71 1.40 1.11 0.85

 Guarantee Fees ($)1 1.09 1.08 1.09 1.11 1.03

 Net Interest Margin (%)1,2 1.15 1.15 1.23 1.25 1.02

 Average Guarantee Fee(bp)3 23.0 23.4 23.8 24.1 23.8

 Return on Common Equity (%) 22.6 22.1 21.9 23.2 22.2

 Dividend Payout Ratio (%)4 28.3 26.0 25.8 25.7 26.8

 BALANCE SHEET POSITION:

 Total Assets ($) 174.7 173.9 137.2 106.2 83.9

 Outstanding Debt ($) 153.1 156.5 119.3 92.1 48.5

 Mortgages:

 Retained Mtge. Portfolio ($) 144.7 137.8 107.7 73.2 55.9

 PCs (excl. PCs in Portfolio) ($) 473.4 473.1 459.0 460.7 439.0

 Retained as % of Total Mtgs.

 in Portfolio and PCs (%) 23.4 22.6 19.0 13.7 11.3

 Capital:

 Equity/Assets & PCs (%) 1.05 1.04 0.98 0.91 0.85

 Equity & Reserves/

 Assets & PCs (%)5 1.16 1.13 1.09 1.04 0.99

Source: Freddie Mac

1. Effective 1/1/96, Freddie Mac reports guarantee fees on retained MBS ( Freddie Mac Participation Certificates or “PCs”)

as guarantee fee income. Previously these fees were included in net interest income.

2. Taxable equivalent net interest income divided by average earning assets. However, for comparability with Fannie Mae,

guarantee fee income on retained MBS for subsequent periods has been estimated and included in net interest income rather

than fee income.

3. Guarantee fees divided by average PCs outstanding net of PCs held in portfolio.

4. Common and preferred dividends divided by net income.

5. Effective 1/1/95, reserves exclude valuation allowance related to impaired loans pursuant to SFAS 114.

Table B
20 OFHEO 1997 Report to Congress

by its need to replace a large volume of low

yielding debt issued during 1993. Net interest

margins have declined at both Enterprises over

the past two years, as their mortgage purchase

volumes have expanded.

Guarantee fee income for Fannie Mae rose 10

percent in 1996, reflecting increased guarantee

volumes and higher average guarantee rates.

Freddie Mac’s guarantee income, as adjusted,

fell for the second consecutive year, as a drop

in its average fee outweighed the small increase in outstanding MBS.

Debt Maturities Lengthened;

Enterprises Re-enter Structured

Note Market

Fannie Mae and Freddie Mac are exposed to

interest rate risk on their debt-funded mortgage portfolios stemming mainly from the

option of homeowners to prepay their mortgage

loans before maturity. The Enterprises manage

this risk primarily by funding with a mix of

callable and non-callable effective long-term

debt. (Effective long-term debt includes the

effect of off-balance sheet swaps that, in conjunction with on-balance sheet debt instruments with short-dated maturities, synthetically create long-term debt instruments.) The

use of effective long-term debt provides protection in increasing interest rate environments

by allowing the Enterprises to maintain stable

funding costs as mortgage assets remain in the

portfolio. Callable features allow the Enterprises to finance at lower costs in declining

interest rate environments as mortgage assets

prepay.

Both Fannie Mae and Freddie Mac increased

the proportion of effective long-term debt to

total debt during 1996. The run-up was in

response to rising rates and, especially in

Fannie Mae’s case, an increase in the proportion of assets with long maturities and fixed

rates. Fannie Mae’s effective long-term debt

increased to 81 percent of total debt in 1996

from 74 percent in 1995, while the proportion

of callable debt remained unchanged at 48

percent of effective long-term debt. Freddie

Mac’s effective long-term debt comprised 72

percent of total debt in 1996, up from 70 percent, and the proportion of callable debt to

effective long-term debt increased one percentage point to 74 percent.

Structured note activity resurfaced at Fannie

Mae and Freddie Mac in 1996 after virtually no

activity the previous year. Leveraged investments in risky structured notes by California’s

Orange County led to its 1994 bankruptcy. This

effectively dried up investor appetite for the

more exotic type of these instruments. Structured notes can be an attractive funding alternative for Fannie Mae and Freddie Mac, either

by swapping the structured note payment for

low cost LIBOR (London Interbank Offered

Rate) or discount note financing (see Box 2 on

page 23).

Credit Indicators Were Stable

During 1996, credit-related losses (charge-offs

plus foreclosure expenses) increased 14 percent

at Fannie Mae and 4 percent at Freddie Mac,

primarily as a result of higher loan volumes.

Credit-related losses as a percentage of the

mortgage portfolio plus MBS outstanding

increased slightly at Fannie Mae in 1996 to 5.1

basis points from 4.8 basis points. Freddie

Mac’s ratio of credit-related losses to the mortgage portfolio plus MBS outstanding decreased

slightly in 1996, to 10.4 basis points, but remains well above Fannie Mae.

Freddie Mac’s credit performance in recent

years has been adversely affected by a relatively high concentration of loans secured by

properties in California. Over the past two

years, the Enterprise has reduced the California share of its conventional loans from 25.5

percent to 21.8 percent.

Single-family delinquencies remained relatively flat at 0.58 percent (58 basis points) in

1996 at both Enterprises (see Figure 15).

That amounted to a two basis point increase

over last year’s rate at Fannie Mae and a two

basis point improvement for Freddie Mac. This

stability in delinquency rates occurred despite
OFHEO 1997 Report to Congress 21

continuing strengthening of an already strong

economy. Loans originated during the refinancing boom years of 1992 and 1993 are now

reaching their peak default years. Although

these loans are of better credit quality than

loans originated prior to 1992, the large proportion of these loans in both Enterprises’ portfolios kept delinquency rates from improving

further.

Multifamily delinquency rates improved significantly at both Enterprises in 1996. Fannie

Mae’s delinquency rate on multifamily loans

declined to 0.68 percent from 0.81 percent in

1995, well below the delinquency rate of 2.65

percent in 1992. The decline was helped, in

part, by low interest rates and a stabilization

in the multifamily rental market. Freddie

Mac’s multifamily delinquency rate declined to

1.96 percent from 2.88 percent in 1995, and is

down significantly from 4.45 percent in 1992.

The decline is a result of the diminishing

impact of multifamily loans originated prior to

1991 and continued high charge-offs of previously delinquent loans. As a result of high

credit losses, Freddie Mac exited the multifamily mortgage market in 1991. Freddie Mac

reentered this market in 1994 and has not

experienced credit losses on multifamily loans

booked since that date.

Source: Fannie Mae and Freddie Mac

0.00%

0.10%

0.20%

0.30%

0.40%

0.50%

0.60%

0.70%

0.80%

1990199119921993199419951996

Freddie Mac Fannie Mae All Conventional

Figure 15

Single-Family Delinquency Rates*

* Loans Delinquent 90 Days or More or in Foreclosure

Figure 16

Enterprises’ Equity Capital as a Percent of

Minimum Capital Requirements

Source: OFHEO

 *Estimated

0%

20%

40%

60%

80%

100%

120%

1990*1991*1992*

1993199419951996

Freddie Mac Fannie Mae

Enterprises Continue to Meet

Capital Requirements

Shareholder equity as a percentage of total

assets and MBS, an indication of capital position, improved for both Enterprises in 1996.

Fannie Mae’s equity was 1.42 percent of assets

plus MBS, up from 1.32 percent in 1995 and

well above the 1.12 percent at year-end 1992.

Similarly, Freddie Mac’s equity increased to

1.04 percent of assets plus MBS, up from 0.98

percent in 1995 and much improved from 0.76

percent at the end of 1992. Improvements in

this capital ratio do not, however, indicate that

the risk the Enterprises pose to the federal

government has declined. In particular, the

ratio ignores the increase in interest rate risk

exposure associated with the Enterprises’ debtfunded purchases of their own mortgage securities.

Each Enterprise exceeded its regulatory minimum capital requirement in 1996. Fannie Mae

surpassed its minimum capital requirement of

$11.5 billion by $1.3 billion while Freddie Mac

exceeded its requirement of $6.5 billion by $200

million (see Figure 16). The statutory minimum capital requirement is less sophisticated

than the risk-based capital standard now being
22 OFHEO 1997 Report to Congress

developed by OFHEO. However, the minimum

capital requirement does take into account the

potentially large differences in risk exposure

between debt-funded mortgages and

securitized mortgages by charging 2.5 percent

of capital for on-balance sheet assets and 0.45

percent for off-balance sheet obligations.

Both Enterprises adjusted their equity capital

structures last year by issuing sizable amounts

of preferred stock, which they offset by

repurchasing comparable amounts of common

stock. Fannie Mae sold $1 billion of preferred

stock and Freddie Mac sold half that amount.

Preferred stock is a cheaper source of equity

funds than common stock, on which investors

expect a higher rate of return. Preferred stock,

however, raises fixed costs to common shareholders, increasing the variability of common

stock earnings.
OFHEO 1997 Report to Congress 23

What Are Structured Notes and Why Do Fannie Mae and Freddie Mac Issue Them?

Structured notes are medium-term debt obligations, most commonly issued by Government-Sponsored Enterprises (GSEs), whose interest or principal payments are determined by an index (like LIBOR or prime) and/or

by a formula. They are usually characterized by a link to a derivative—an underlying swap in most cases—and

designer cash flows to meet specific investor needs. Structured notes can be as simple as a straight floater, or

more complex, either with the use of leverage, more than one index, or inverse floating formulas. The common

types of structured notes issued by GSEs are defined in the box below.

Box 2

Structured Note Activity Increased in 1996

Structured notes can provide an attractive funding alternative for Fannie Mae and Freddie Mac (and often

other issuers), typically by swapping the structured note payment for low cost LIBOR or discount note

financing. As a result of the swap, Fannie Mae and Freddie Mac do not bear the risk associated with potentially complex payment formulas. As issuers of a structured note, they receive favorable debt financing from

the swap counterparty partly as a result of their GSE status.

De-Levered Note: a note whose coupon includes a fractional percentage of the reference

index, such as (0.5% x 10 year CMT) + 2.0%. A de-levered note coupon will lag the

movement of the particular index, resulting in less volatile returns over time.

Dual Index Bond: a structured note whose coupon is dependent on the difference

between the level of two indices. For example, 10-year CMT - 6-month LIBOR + 0.5%. An

investor in a dual index bond is taking a position based on the expectation of an increase in

the yield spread between the two indices.

Indexed-Amortizing Note: a note whose principal repayments are based on a predetermined amortization schedule. Issuances by Fannie Mae and Freddie Mac are typically

linked to mortgage collateral and therefore mimic the paydown of a mortgage asset.

Inverse Floater: a floating rate note whose coupon varies inversely with a particular index,

for example, 10% - 6-month LIBOR. An investor in an inverse floating rate note is taking a

position that the reference index will fall, increasing the coupon rate on the structured note.

Range Bond: a bond whose coupon is dependent on the number of days that the

reference index is within a pre-defined collar. For example, 3-month LIBOR + 1.0% for each

day that 3-month LIBOR is between 3 percent and 9 percent. The bond would pay 0

percent for each day the reference index is outside the specified range.

Step-Up Note: a structured note that initially pays a fixed rate of interest to the investor for

a specified period of time (the lockout period). At the expiration of a lockout period, the

bond is either called by the issuer, or steps up to a higher rate. For example, 7.2 percent

until July 1998 at which time the bond is callable. If not called, the bond will pay 8 percent

until the year 2006.

Straight Floater: a floating rate instrument whose coupon varies as a function of a single

index like 6-month LIBOR.
24 OFHEO 1997 Report to Congress

0

2

4

6

8

10

12

14

Pre- 92

19921993199419951996

$Billions

0

10

20

30

40

50

60

70

80

90

100

# of Deals

(Left Axis) (Right Axis)

0

50

100

150

200

250

300

350

3/92

12/92

9/936/943/95

12/95

9/96

Basis Points

Enterprise Structured Note Issuance Yield Spread Between the 10-Year Constant Maturity

Treasury and 3-Month LIBOR

Revival in Structured Note Activity

Fannie Mae and Freddie Mac issued 62 structured note deals in 1996, totalling $2 billion. In addition, there have

been 25 deals totalling $1.4 billion in the first quarter of 1997. While these figures are small compared to the $13 billion in issuances each year in 1993 and 1994, it represents a revival of this market for Fannie Mae and Freddie Mac

after virtually no activity in 1995 (see Figure at bottom left).

Among the reasons for the drop-off in structured note activity since 1994 are the change in the yield curve, and lack

of investor appetite for the riskier types of these instruments. Structured notes can provide higher returns relative to

other fixed income investments if the investor’s particular view with respect to the volatility, stability, or direction of

rates is realized. Consequently, a steeper yield curve as experienced in 1992 through 1994 (see Figure at bottom

right) provided investors more opportunity to:

-- Increase returns by taking advantage of the spread between long and short rates with coupons such as:

10-year CMT - 6 month LIBOR + 0.5%

-- Increase returns by leveraging or de-leveraging the volatility of the underlying index with formulas such as:

 0.5% x 10-year CMT + 2.0%

-- Speculate on the magnitude and direction of interest rate movements through instruments such as inverse

floaters:15% - (2 x 3 month LIBOR).

Note: CMT= Constant Maturity Treasury

Current Issuances Are in Less Complex Structures

Step-up notes comprised the majority of all GSE structured note issuances (including the Federal Home Loan

Banks, Farm Credit Banks and the Student Loan Marketing Association), averaging 34 percent of all issues in 1992

through 1994. Step-up note issuances increased to 70 percent of all issuances in 1995, and were 56 percent of total

issuances in 1996. Indexed amortizing notes (IANs), which comprised 9 percent of all issuances in 1993 and 1994,

were the second major structured note type in 1996, comprising 22 percent of all agency issues in the year.

Indicative of the relative lack of investor appetite for riskier securities, there have been virtually no issuances of

speculative types of structured notes such as inverse floaters and range bonds. Combined, these types of notes

represented 13 percent of all issuances in 1994 and 14 percent in 1993. In addition, consistent with the flattening of

the yield curve, there have been virtually no issuances of structured notes designed to take advantage of volatility or

spread such as de-levered notes and dual index bonds. These instruments comprised 36 percent of all issuances in

1994 and 33 percent in 1993.

Source: Bloomberg Source: Bloomberg
OFHEO 1997 Report to Congress 25

Capital Classification and

Minimum Capital

The Federal Housing Enterprises Financial

Safety and Soundness Act of 1992 (Title XIII of

P.L. 102-550) (the Act) requires OFHEO to

determine the capital classifications of Fannie

Mae and Freddie Mac for purposes of financial

safety and soundness. The Act requires that

these determinations be made “not less than

quarterly.” The classifications are: adequately

capitalized, undercapitalized, significantly

undercapitalized, and critically undercapitalized. The Act gives the OFHEO Director

“prompt corrective action” enforcement authorities if an Enterprise is classified other than

adequately capitalized.

To qualify as adequately capitalized, an Enterprise must meet both minimum and risk-based

capital standards. However, during the period

that OFHEO’s risk-based capital standard is

under development, and for one year after

publication of a final risk-based capital rule,

only the minimum capital standard applies.

During this period, an Enterprise is considered

adequately capitalized if its core capital --

common stock, perpetual noncumulative preferred stock, paid-in capital and retained earnings -- equals or exceeds its minimum capital

requirement.

The minimum capital requirement is designed

to establish an essential amount of capital that

an Enterprise must hold as a cushion against

losses from broad business categories. It is

computed on the basis of leverage ratios applied

to all assets (2.50 percent) and off-balance sheet

obligations (0.45 percent), with more complex

rules applied to interest rate and foreign exchange contracts. OFHEO implemented the

minimum capital provision of the Act by publishing a proposed minimum capital regulation

for public notice and comment on June 8, 1995.

After considering the comments received,

OFHEO published the final regulation on July

8, 1996. It is codified in the Code of Federal

Regulations at 12 CFR Part 1750.

Based on the minimum capital requirement,

OFHEO has classified Fannie Mae and Freddie

Mac adequately capitalized in each quarter

since June 30, 1993.

Risk-Based Capital

The Act requires OFHEO to establish a riskbased capital standard, using a stress test, to

evaluate the capital adequacy of Fannie Mae

and Freddie Mac. This risk-based capital test,

to be administered at least quarterly, is currently under development by OFHEO. When

operational, the test will subject the businesses

of Fannie Mae and Freddie Mac to a set of

financial shocks simulating the effects, over a

10-year period, of very large, sustained movements in interest rates accompanied by widespread mortgage defaults. The risk-based

capital level for an Enterprise is the amount of

capital the Enterprise must hold to maintain a

positive capital position throughout the 10-year

stress period, plus an additional 30 percent to

cover management and operations risk.

Capital Classification and Regulation of

Fannie Mae and Freddie Mac

OFHEO’s Regulatory Activities
26 OFHEO 1997 Report to Congress

OFHEO’s stress test must project credit losses

on a national scale comparable to the worst

historical mortgage credit loss in any region of

the country. OFHEO refers to this credit loss as

the “benchmark loss experience.” This is a

description of the default and severity behavior

of specific mortgage loans in a particular time

and place, whose characteristics are described

in the Act.

The risk-based standard is a critical aspect of

the safety and soundness oversight of the two

Enterprises. Unlike OFHEO’s minimum capital

standard, which is based on fixed leverage

ratios, the risk-based standard is designed to

address specific credit risk exposures and

exposure to interest rate changes. OFHEO’s

risk-based capital standard will also respond to

future changes in either of the Enterprise’s risk

profiles. For example, a decline in house prices,

causing homeowners to have less equity in their

properties and increasing the probability of

default, will put upward pressure on capital

requirements. A rising house price scenario

would produce the opposite effect.

Although the product of OFHEO’s risk-based

capital test will be a single capital number, the

test effectively creates a large number of

marginal capital requirements for different

types of activities, including a wide variety of

investments, guarantees and funding strategies. This provides the Enterprises with flexibility to adjust the amount of capital they maintain or their exposure to interest rate risk and

credit risk.

Development of the Risk-Based

Capital Regulation

OFHEO has made significant progress toward

completing its risk-based capital regulation.

n Feb. 7, 1995 -- Advance Notice of Proposed Rulemaking (ANPR) laid out

OFHEO’s basic approach to the stress test

and invited public comment on a range of

issues involving stress test development.

n March 21, 1996 -- OFHEO began publishing the House Price Index (HPI), a new

quarterly government economic indicator

and a key component of the stress test. The

HPI, a weighted repeat sales index, measures average changes in house prices at the

national, regional and state level.

n June 10, 1996 -- OFHEO published a

Notice of Proposed Rulemaking (NPR)

describing two key elements of the riskbased capital test -- the benchmark loss

experience and the HPI. The NPR discussed

the methodology for establishing the benchmark loss experience, defining the basis for

determining Enterprise credit losses in the

stress test. It also proposed that OFHEO

use the HPI to estimate changes in the

value of properties securing single-family

mortgages owned or guaranteed by the

Enterprises.

n 1997 -- OFHEO is working on a second

NPR that will address assumptions about

interest rates and mortgage performance

and other issues not covered in the first

NPR.

Creating a New Regulatory Tool

A key element of OFHEO’s mission is development of the methodology for simulating Enterprise performance. Establishing this methodology requires creation of a database to support

OFHEO’s regulatory and supervisory activities

(the database), and a Financial Simulation

Model (FSM). The database and the FSM are

the foundation for the development and operation of the risk-based capital stress test as well

as the monitoring of credit and interest rate

exposure on an ongoing basis, the analysis of

Enterprise financial performance over time,

basic research on credit and interest rate risk

relevant to the supervision of the Enterprises,

and research on public policy issues relating to

safety and soundness. For example, the database includes extensive detailed historical and

current data on the Enterprises’ activities. The

FSM must simulate the behavior of the Enterprises’ assets, liabilities, and off-balance sheet
OFHEO 1997 Report to Congress 27

obligations under adverse credit and interest

rate conditions. OFHEO is currently the only

federal financial regulator statutorily required

to apply a stress test as part of its capital

regulation.

The Database

The database includes extensive data on the

historical performance of loans purchased by

Fannie Mae and Freddie Mac as well as on the

Enterprises’ current books of business. Historical data provides a basis for evaluating how

Fannie Mae and Freddie Mac may perform

under economic stress. Current and historic

business data is used to monitor Enterprise

financial performance and to establish starting

positions for simulations of Enterprise performance.

The Act requires that OFHEO’s risk-based

capital regulation be based upon actual risk

exposures of Fannie Mae and Freddie Mac. To

achieve this, OFHEO needs Enterprise data at

a highly disaggregated level. To minimize

regulatory reporting requirements, OFHEO

collects and processes instrument-level data

(data on individual mortgages, debentures, or

swaps), as provided by the Enterprises. The

Enterprises maintain their data in different

formats and database structures. In order to

make the data consistent, OFHEO created a

single-format database to normalize the data.

Financial Simulation Model

The FSM is comprised of econometric models

that simulate the performance of Enterprise

assets and obligations. It also incorporates

computer programs to simulate cash flows,

implement assumptions about Enterprise

operations, and translate cash flows into pro

forma financial statements. OFHEO’s work on

the various components of the FSM is summarized below.

n Interest Rates -- Interest rates are an

important determinant of Enterprise performance. They directly affect an Enterprise’s

net interest margin -- the difference between the interest it receives on mortgages

it holds in portfolio and the interest it pays

on its liabilities. To the extent that the

Enterprise does not lock in a profitable

spread on the mortgage assets purchased

for investment, changes in interest rates are

an important risk factor. Both the absolute

level of rates and the shape of the yield

curve affect the net interest margins of the

Enterprises.

OFHEO has developed a time series database of interest rates relevant to Enterprise

financial performance, including U.S. Treasury yields, yields on various mortgage

products, Enterprise borrowing rates, and

other rates and yields associated with

derivative products or contracts. This database, together with econometric models, will

allow the FSM to simulate future interest

rate environments.

n House Prices -- House prices are a

major determinant of mortgage performance. Rising house prices make it easier

for a homeowner to refinance or, in the

event of a default on mortgages owned or

guaranteed by Fannie Mae or Freddie Mac,

for the Enterprise to reduce its credit losses.

The FSM uses actual house price trends to

estimate how much equity borrowers have

in their homes, as measured by the current

(as opposed to original) LTV.

OFHEO is also analyzing the extent of any

relationship between home prices and

interest rates. The existence of such a

relationship could have important implications for the performance of Enterprise

mortgages during a stress period.

n Mortgage Performance -- Mortgage

performance--whether and when a mortgage

is prepaid or defaults, and in the latter case,

how much it costs -- translates directly into

Enterprise financial performance. The FSM

includes models of default and prepayment

and loss severity for both single-family and

multifamily mortgages. The models produce

simulated default rates, loss severities, and
28 OFHEO 1997 Report to Congress

prepayment rates for mortgages with common sets of characteristics (e.g., product

type, origination year, region, original LTV).

The models have been developed based on

statistical analysis of the complete historical

loan-level data of the two Enterprises.

OFHEO’s approach to modeling defaults

and prepayments of single-family mortgages

builds on established statistical methods,

but also involves new approaches in several

respects. In the past year, OFHEO has

developed a separate model for adjustablerate mortgages that explicitly accounts for

the impact of payment shock on borrowers.

With respect to single-family loss severity,

OFHEO has developed an original approach

for determining the cost of losses associated

with the difference between the loan

amount and proceeds of a foreclosure sale.

OFHEO has also broken new ground in its

research on multifamily mortgage performance. The first product of this research is

an innovative model of multifamily default

and prepayment that considers both an

owner’s equity and the property’s cash flow,

simulating both of these as a function of

economic conditions. OFHEO is performing

the research required to develop a model of

multifamily loss severity.

n Other Credit Factors -- Fannie Mae

and Freddie Mac are required by law to

provide credit enhancement for loans they

purchase or guarantee where the LTV is

greater than 80 percent. Private mortgage

insurance is the most common form of credit

enhancement, but participation agreements

and recourse agreements are also authorized. Since these credit enhancements

provide revenues to offset some mortgage

losses, they must be incorporated in the

FSM. OFHEO has developed computer

programs that simulate the performance of

credit enhancements, consistent with their

most important characteristics and the level

of economic stress of a given scenario.

n Operations -- Enterprise operations that

can be simulated in the FSM include cost of

operations, new borrowing to finance an

Enterprise’s portfolio, and dividend payouts.

The FSM simulates Enterprise operations

under a “wind-down” assumption, that is,

the assumption that the Enterprises add no

new business after the start of a simulation.

The FSM scales operating expenses to the

decline in the Enterprises’ businesses. In

the case of new borrowing, it simulates

Enterprise debt issuance whenever, during

the course of a simulation, funding is insufficient to support current asset balances.

With respect to dividends, the FSM simulates payouts based on operating results

and statutory requirements.

n Cash Flows -- Simulated cash flows of

the Enterprises’ assets, liabilities, and offbalance sheet obligations (e.g., mortgagebacked securities and interest rate swaps)

are produced by the FSM. Sophisticated

treatment of cash flows is particularly

important because, in recent years, the

Enterprises have purchased a growing

volume of complex mortgage derivative

products, issued substantial amounts of

derivative debt securities (i.e., structured

notes) and entered into many billions of

dollars in derivative contracts. Many of

these products and arrangements are extremely sensitive to interest rates, and are

likely to behave in complex ways in the

event of significant swings in interest rates

-- swings such as those associated with the

risk-based capital stress test.

OFHEO completed development of basic

liability and non-mortgage derivative cash

flow generators during 1996. Generating

cash flows for complex liabilities and derivatives requires OFHEO to “reverse engineer”

each security and derivative transaction.

This involves creating computer code for a

given transaction to guide the cash flows

according to a set of rules. OFHEO has

contracted with a commercial service bureau to supplement its internal reverse

engineering capability.
OFHEO 1997 Report to Congress 29

n Financial Reports -- OFHEO’s FSM

incorporates software that translates cash

flows of an Enterprise’s financial instruments and activities into pro forma financial

statements.

OFHEO’s House Price Index

(HPI)

In March 1996, OFHEO began publishing a

quarterly House Price Index (HPI), designed to

capture average changes in the value of singlefamily homes state by state, regionally, and

nationwide. The HPI measures average price

changes in repeat sales or refinancings on 8

million single-family mortgages purchased or

securitized by Fannie Mae and Freddie Mac

during the past 22 years. The combined mortgage records of these two Enterprises comprise

the nation’s largest database of mortgage

transactions. The HPI is the government’s most

comprehensive statistical measure of changes

in the nation’s housing values.

In developing the stress test, OFHEO is required to use a house price index to account for

changes in the loan-to-value ratios of mortgages

held or guaranteed by Fannie Mae or Freddie

Mac. OFHEO has determined that for purposes

of the stress test, the HPI produces the most

accurate picture of house price changes of any

available index or survey. In a Notice of Proposed Rulemaking published June 10, 1996,

OFHEO formally proposed to use the HPI as an

element in the stress test.

The HPI is updated each quarter as additional

mortgages are purchased by the Enterprises

and additional repeat transactions are identified. These data are combined with the data of

previous years stretching back to January

1975. OFHEO publishes the HPI approximately two months after the end of the previous quarter. (see Figures 4 and 5 on page

12)

Rating Agency Review of the Enterprises

In April 1996, Chairman Richard Baker of the

House Banking Subcommittee on Capital

Markets, Securities, and Government Sponsored Enterprises, asked OFHEO to obtain

credit ratings for Fannie Mae and Freddie Mac

from a nationally recognized statistical rating

organization on a risk to the government basis.

OFHEO has statutory authority to request a

rating agency review.

A contract was competitively awarded to

Standard & Poor’s (S&P). The rating agency

was asked to evaluate the risk that each Enterprise would be unable to meet its obligations

without a commitment of taxpayer funds. S&P

was asked to express that risk in the form of its

standard credit rating schedule. The evaluations were to be “point-in-time” ratings, valid

for the date of the report only.

In a Feb. 18, 1997 letter to Chairman Baker,

OFHEO reported:

Standard & Poor’s determined that both Enterprises currently merit a rating of AA-. These

ratings show a clear improvement from six years

ago when Standard & Poor’s last publicly

conducted comparable evaluations. At that time,

Freddie Mac was rated A+, and Fannie Mae

was rated A-. In explaining its current ratings,

Standard & Poor’s notes that “risk is mitigated

by increased governmental oversight begun in

1992 with the passage of the [Federal Housing

Enterprises Financial Safety and Soundness]

Act and the chartering of OFHEO.” That has

resulted in higher Enterprise capital ratios, a

series of examinations with recommendations

that have been adopted by the Enterprises, and

a continuing supervisory and enforcement
30 OFHEO 1997 Report to Congress

structure featuring prompt corrective action

measures.

The report notes several other Enterprise

strengths. Areas of improvement include hedging techniques and consistent records of strong

profitability, which in Fannie Mae’s case did not

exist to nearly the same degree six years ago. As

before, both Enterprises’ ratings benefit substantially from their nationally diversified asset

portfolios and from their charters. Those charters give them a protected duopoly position and

create a perception among investors that their

securities are effectively government guaranteed,

which greatly enhances the Enterprises’ liquidity. As Standard & Poor’s concludes, “While the

market pricing of GSE debt is not immune to

concerns about creditworthiness, this concern

has historically been reflected in higher pricing

of debt, but no GSE has ever been subject to a

liquidity crisis due to inability to access funding.”

On the other hand, the report concludes that the

Enterprises’ current capital positions are relative

weaknesses: “Both companies maintain capital

levels that are relatively low when compared

with what Standard & Poor’s would expect to

see at fully private companies with similar risk

profiles at the ‘AA-’ rating level.” And Standard

& Poor’s states that “stronger levels of capital

would provide a higher measure of protection”

under severe credit or interest rate scenarios.

Standard & Poor’s evaluations provide OFHEO

and the Congress with an additional perspective

on the risks posed by the government’s sponsorship of the Enterprises. Standard & Poor’s

supports OFHEO’s view that the Enterprises

present no near-term danger to taxpayers. At the

same time, OFHEO believes that these ratings

do not substitute for OFHEO’s own more detailed analyses of the Enterprises conducted in

the course of examinations and otherwise.

Nor do they substitute for OFHEO’s risk-based

capital requirements that are currently under

development. These requirements will be based

on statutorily specified risk scenarios that are

qualitatively different from those considered by

Standard & Poor’s. And they serve a somewhat

different purpose. Standard & Poor’s uses stress

tests in conjunction with its understanding of

management goals, strategies, and capabilities

to anticipate risk exposures and vulnerabilities

over the next several years. Passing or failing a

specific test on a specific date is not determinative in rating the creditworthiness of an ongoing

firm. OFHEO’s stress test, however, is a key tool

in its regulatory apparatus. The test must be

met on a quarterly basis and, properly designed,

will provide appropriate incentives to limit

Enterprise risk-taking.

The report also is consistent with OFHEO’s

examination conclusions that credit and interest

rate risk management has been strong at the

Enterprises, but stresses that, given their capital

positions, very stringent management controls in

these areas is essential. OFHEO agrees and will

continue to monitor closely Enterprise risk

management.
OFHEO 1997 Report to Congress 31

OFHEO’s Office of Examination and Oversight

(OEO) conducts a comprehensive program of

examination activities to determine the condition of Fannie Mae and Freddie Mac for the

purpose of ensuring their financial safety and

soundness. These activities include on-site

examinations and off-site financial analysis and

supervisory monitoring, as well as ongoing

communication with the board of directors and

management of both Enterprises. OEO’s examination program complements OFHEO’s quarterly capital classification in providing comprehensive oversight of the financial safety and

soundness of each Enterprise.

OFHEO’s goals of examination derive from

OFHEO’s mission.

each Enterprise’s activities and the Enterprise’s

management of those risks, and (2) examinations use a top-down approach. Examinations

focus on risk because the negative consequences

of risk-taking may have an adverse impact on

an Enterprise’s safety and soundness. Using a

top-down approach allows OFHEO to employ

its examination resources effectively and

efficiently.

OFHEO has identified six categories of risk for

examination. They are credit risk, interest rate

risk, business risk, information systems and

technology risk, operations risk, and corporate

governance risk. OEO has designed examinations to assess each of these risk areas.

OFHEO recognizes that the Enterprises’ business requires that they assume risk. The purpose of OFHEO examinations is not to eliminate risk at the Enterprises, but to ensure that

each Enterprise manages its risks in a manner

that is appropriate for the level of risk assumed. OFHEO also recognizes that the risk

exposure of the Enterprises should be consistent with their public purpose as reflected by

the charter acts for these two governmentsponsored enterprises.

OFHEO defines risk management as being

those policies, procedures, practices, information systems, and internal controls for:

n identifying;

n measuring;

n controlling; and

n monitoring risk at each Enterprise.

Risk identification focuses on detecting all

significant sources of risk. Risk measurement

means quantifying the Enterprise’s exposure to

a particular risk. Risk control is the

Enterprise’s process for keeping risk exposure

within the limits approved by the board of

directors. Risk monitoring refers to the process

for oversight of risk by the Enterprise’s board of

directors and management.

 OFHEO EXAMINATION GOALS

n Identify the significant sources of risks

inherent in each Enterprise’s current and

planned business activities and products.

n Evaluate the effectiveness of each

Enterprise’s system for identifying,

measuring, controlling, and monitoring

risks.

n Communicate examination findings,

conclusions, and recommendations to

each Enterprise’s board of directors and

management in a clear, concise, and

timely manner.

n Obtain commitments from the board of

directors and management for prompt

correction of any significant deficiencies

in risk management and internal

controls, as well as violations of laws and

regulations.

n Verify that deficiencies and violations are

corrected in an effective and timely

manner.

Enterprise Examination

OFHEO’s framework for conducting on-site

examinations is based on two key principles:

(1) examinations focus on the risks present in
32 OFHEO 1997 Report to Congress

To conduct examinations effectively, OFHEO

has identified the critical components of a

comprehensive risk management system. They

include:

n Thorough, ongoing oversight by the board

of directors;

n Effective, clearly communicated policies

and procedures;

n Extensive internal controls that include

prudent risk exposure limits, clear

accountability, segregation of duties, and

independent review; and

n Rigorous internal audit and external

audit functions.

If an examination identifies deficiencies in an

Enterprise’s management of risk, OFHEO

directs the Enterprise to address the deficiencies in a manner consistent with the seriousness of OFHEO’s safety and soundness concern.

OFHEO requires the Enterprise to correct

significant deficiencies immediately. When

appropriate, OFHEO also will recommend that

the Enterprise enhance risk management to

reflect current “best practices.”

To achieve an extensive knowledge of the risks

present in each Enterprise’s business activities

and of the management practices and internal

controls at each Enterprise, OFHEO’s initial

program of examination consisted of a cycle of

separate comprehensive examinations of each

of the six risks identified by OFHEO. To date,

OFHEO has concluded the examinations of

credit risk, interest rate risk, business risk, and

corporate governance risk at each Enterprise.

Examinations of information systems and

technology risk currently are in progress.

Examinations of operations risk are scheduled

for completion by the end of 1997.

At the conclusion of the initial cycle of separate

examinations of each risk, OFHEO will transition to an examination program that assesses

all risks at each Enterprise at the same time.

Concurrent, continuous examination will allow

OFHEO to target examination resources to

high-priority risk areas at each Enterprise.

This program of concurrent, continuous examination will be supported by a system of comprehensive monitoring to ensure that OFHEO

identifies and responds in a timely manner to

changes in the risk profile of each Enterprise.

Continuing two-way communication between

OFHEO and each Enterprise’s board of directors and management is another essential

element of OFHEO’s examination philosophy.

OFHEO communicates with the Enterprises to

inform them of important regulatory initiatives

and to request information for financial analysis and supervisory monitoring. In turn,

OFHEO expects the Enterprises to keep

OFHEO informed of significant issues relating

to their internal operations and external operating environment. Examples of such issues

include projected earnings levels, anticipated

changes in the structure or level of capital,

plans for new products and services, potentially

consequential changes to existing products and

services, changes in senior management and

organizational structure, and the effect of

anticipated accounting changes.

OFHEO is also developing an evaluative rating

system to provide examiners with a uniform

framework for evaluating each Enterprise’s risk

exposure and risk management. The evaluative

rating system framework includes a definition

of each type of risk examined by OFHEO and a

structure for assessing risks and risk management processes. The framework assesses the

quantity of risk exposure and the quality of risk

management independently.

OFHEO is incorporating these and other examination-related topics into an examination

handbook. The handbook will serve as both a

guide for OFHEO examiners and a reference for

the Enterprises on OFHEO’s examination

approach.

In the twelve months since June 16, 1996,

OFHEO completed a targeted examination of

data integrity at Freddie Mac, and examinations of business risk at both Fannie Mae and

Freddie Mac. OFHEO examinations of information systems and technology risk currently are

in progress at the Enterprises. A discussion of

OFHEO’s examination activities over the past

year for each Enterprise follows.
OFHEO 1997 Report to Congress 33

Data Integrity Examination

OFHEO conducted a Data Integrity Examination at Freddie Mac because of ongoing difficulties with the accuracy, completeness, and

consistency of Freddie Mac’s data deliveries to

OFHEO for the development of the risk-based

capital regulation. The examination also addressed other data integrity weaknesses identified in prior examinations.

Data integrity encompasses the accuracy,

completeness, and consistency of the information used to operate a business. It also affects

the data delivered to OFHEO by the Enterprises for the development of the simulation

model supporting establishment of the riskbased capital regulation and off-site monitoring. Receipt by OFHEO of inaccurate, incomplete, or inconsistent data can cause significant

inefficiencies and can hamper development of

the Enterprise simulation model.

Objectives and Scope

The objectives and scope of this examination

were to assess the:

n Effectiveness of internal controls over

data integrity for mortgages, debt and

derivatives, investments, and analytics

for Freddie Mac’s internal use.

n Effectiveness of internal controls over

data deliveries to OFHEO of asset, debt

and derivatives, and investment data.

n Adequacy of management plans for

improving internal controls over data

integrity.

Results and Conclusions

OFHEO determined that internal controls over

data integrity for financial mortgage data are

effective. Financial mortgage data encompass

information necessary for accurate transactions

and financial reporting. Internal controls over

nonfinancial data (i.e., certain demographic and

geographic data) are inadequate to assure

integrity. Freddie Mac is strengthening internal

controls over data integrity by converting to

reliance on a central repository for mortgage

data.

Systems controls over legacy, (i.e., existing

systems that are being replaced) derivative,

debt and securities transactions systems are

not adequate to ensure data integrity; however,

compensating management controls (primarily

manual reconciliations) are adequate for financial reporting and internal uses of data. Freddie

Mac is strengthening systems controls over

data integrity by replacing legacy systems with

a central repository for derivative, debt, and

securities transactions.

OFHEO made recommendations to enhance

internal controls over data integrity for Freddie

Mac’s internal use. Freddie Mac agreed to

implement all recommendations.

OFHEO determined that internal controls over

data deliveries to OFHEO were ineffective.

OFHEO required Freddie Mac to significantly

enhance internal controls to ensure the accuracy, completeness, consistency, and timeliness

of data deliveries to OFHEO. In response,

Freddie Mac created a regulatory reporting unit

in the Corporate Accounting Department responsible for managing data submissions to

OFHEO with a level of control consistent with

Freddie Mac’s financial reporting process and

other production processes. Furthermore,

Freddie Mac has established quality control

standards for all data delivered to OFHEO.

OFHEO determined that management plans to

ensure data integrity were incomplete. In

response, Freddie Mac submitted comprehensive plans (principally detailed implementation

and conversion plans with firm schedules) to

correct data integrity control deficiencies.

OFHEO is monitoring Freddie Mac’s progress

in implementing improved internal controls and

in converting internal users from legacy systems to effectively-controlled data sources.
34 OFHEO 1997 Report to Congress

Business Risk Examination

Business risk is the potential that an event or

action will adversely affect an Enterprise’s

ability to achieve business objectives and

successfully execute business strategies. Business risk can be heightened by changes in the

structure of the mortgage finance industry, in

the demand for mortgages, and in laws and

regulations governing these markets. Business

risk can also be affected by the design and

implementation of the Enterprise’s business

strategies.

OFHEO conducted examinations of business

risk at Fannie Mae and Freddie Mac. The

examinations focused on the single-family

business at each Enterprise. The examinations

assessed the quality of each Enterprise’s management of business risk. For the purpose of

these examinations, the quality of business risk

management at each Enterprise was assessed

as strong, adequate, or weak, based on the

ability of Enterprise management to identify,

measure, control, and monitor business risk

exposure. This assessment was made for the

management of each source of business risk

and for the overall management of business

risk at each Enterprise.

n Strong risk management indicates that

the quality of risk management substantially exceeds safety and soundness

standards. Strong risk management is

characterized by the implementation of a

sound and comprehensive risk management framework for identifying, measuring, controlling, and monitoring all

relevant sources of business risk, and by

ongoing efforts to enhance and improve

risk management practices to meet the

evolving standards for best practices.

n Adequate risk management indicates

the quality of risk management meets

safety and soundness standards. Adequate risk management is characterized

by the implementation of a risk management framework for identifying, measuring, controlling, and monitoring the

significant sources of business risk. There

are no significant weaknesses in the risk

management practices, but such

practices can be enhanced and improved.

n Weak risk management indicates the

quality of risk management fails to meet

safety and soundness standards. Weak

risk management is characterized by

significant or pervasive weaknesses in

the risk management framework for

identifying, measuring, controlling, and

monitoring the sources of business risk,

or by the failure to address significant

sources of business risk.

Objectives

The objectives of each business risk examination were to:

n Identify the primary sources of business

risk associated with the single-family

business;

n Assess the development of the

Enterprises’ strategies to respond to

these sources of business risk; and

n Evaluate the risk management processes

and internal controls associated with

implementation of the Enterprise’s

business strategies.

Mortgage Finance

Industry Structure

New Product

Development

Home Mortgage

Delivery System Compliance

Consolidation

Competition

Other Industry

Changes

Product Engineering

Enabling

Technology

Affordable Housing

Post Implementation

Review

Automated

 Underwriting

Mortgage Scoring

Enabling Technology

Risk-Based Pricing

Compliance Process

Fair Lending Efforts

Primary Sources of Business Risk
OFHEO 1997 Report to Congress 35

Scope

The examination encompassed strategic business decisions and the implementation of those

decisions for the single-family business.

OFHEO identified the following four primary

sources of business risk to the Enterprises:

Mortgage Finance Industry Structure:

Business risk resulting from changes in the

mortgage finance industry structure includes

consolidation of seller/servicers, increased or

new competition, and other structural changes,

such as demographics, economic trends, or

changes in laws and regulations that affect the

Enterprises’ businesses. The examinations

reviewed each Enterprise’s response to changes

in the mortgage finance industry.

New Product Development: Business risk

associated with new product development

results from changes in the demand for certain

mortgage products and services, and from the

risk that new products and services will not be

accepted by the market. To assess the potential

business risk exposure from such business

expansion initiatives, the examinations reviewed each Enterprise’s new product development strategies and affordable housing initiatives. Each Enterprise’s new product development strategies were identified and assessed by

focusing on board of directors and management

oversight of strategic initiatives and the

Enterprise’s product engineering process,

including policies and procedures that ensure

consistent application of the process. Enabling

technology was reviewed to ensure effective

support for the Enterprise’s new product development plans. Risk management processes

associated with implementation of each

Enterprise’s new product development strategies were assessed by focusing on product

engineering, internal controls, and the postimplementation review process.

Home Mortgage Delivery System: A significant source of business risk arises from changes

in the home mortgage delivery system that

result from technological advances and implementation of automated underwriting. Technological changes in the delivery systems for

home mortgages have dramatically altered how

Fannie Mae and Freddie Mac conduct their

businesses. As part of the review of business

risk management, the examinations reviewed

the potential business risk associated with

development of automated underwriting. The

examinations assessed business strategies

relating to automated underwriting at each

Enterprise, the incorporation of mortgage

scoring into the single-family business, and the

application of risk-based pricing by the Enterprises.

Compliance: Failure to comply with laws and

regulations can expose the Enterprises to

significant legal liability that could adversely

affect their earnings and capital and damage

their reputations. The compliance component of

the examinations focused on each Enterprise’s

process for ensuring that it complies with

applicable laws and regulations. The scope of

the examinations did not include an evaluation

as to whether the Enterprises were complying

with specific laws and regulations. The examinations of Fannie Mae and Freddie Mac included an assessment of each Enterprise’s effort

to comply with the federal prohibitions against

discrimination in the purchase of mortgages set

forth in the Act, since these prohibitions expressly focus on the Enterprises. To assess

these efforts, the examinations reviewed the

management systems that identify, monitor,

and control compliance with applicable laws

and regulations at each Enterprise.

Results and Conclusions:

Fannie Mae

Overall, Fannie Mae’s management of business

risk, as it relates to the single-family business,

is generally strong. Management has effectively

identified the primary sources of business risk

and measured the potential adverse impact of

business risk in the single-family business.

Fannie Mae consistently monitors and reports

on specific strategies that have been developed

to respond to sources of business risk. These

strategies are consistent with corporate goals

and objectives. Management has established a
36 OFHEO 1997 Report to Congress

system of internal controls to ensure the effective design and implementation of strategies to

respond to the sources of business risk. Certain

aspects of Fannie Mae’s management of business risk, however, can be improved. Such

enhancements to Fannie Mae’s risk management can be made in the normal course of

business.

Fannie Mae’s management of business risk

from changes in the mortgage finance industry

structure is strong. Management has appropriately identified this as a primary source of

business risk in the single-family business.

Fannie Mae has responded to this source of

business risk with specific strategies that are

flexible and evolve as the market changes.

Fannie Mae has appropriately implemented

those strategies. Corporate goals are supported

by specific strategies and tactics that include

defined management responsibility and

accountability. Performance is measured by

specific metrics and monitored at the senior

management and board level.

Fannie Mae’s management of the business risk

associated with the new product development

process is adequate, but can be enhanced. The

board of directors and management have appropriately identified business risk associated with

new product development and developed new

product development strategies that facilitate

achievement of corporate objectives and assist

the Enterprise in meeting industry, market,

and customer needs. Risk management processes and internal controls associated with the

design and implementation of new product

development strategies are effective, but can be

improved. Management has already begun to

improve the new product development process

by developing policies and procedures and

improving financial reporting for product development. OFHEO also recommended that

Fannie Mae establish additional performance

measures that are consistent with Fannie

Mae’s internal performance indicators.

Fannie Mae’s management of business risk

from changes in its home mortgage delivery

system is strong. Management effectively

identifies and measures potential business risk

exposure associated with the use of its automated underwriting system. Fannie Mae has

developed an effective strategy for the development and implementation of its automated

underwriting system that is focused on improved credit risk measurement and cost

savings objectives. Fannie Mae has improved

its credit risk measurement capability by

incorporating mortgage scores into its operations and its pricing. Effective internal control

processes have been established to monitor and

mitigate this source of business risk. Management reports all of the significant performance

characteristics to the board of directors.

Fannie Mae’s process for managing the business risk from failure to comply with laws and

regulations is adequate. Fannie Mae’s integrated approach to compliance ensures that

business unit management and operating

committees are kept informed of and are able to

resolve compliance issues as they arise. Fannie

Mae has designed its compliance efforts to

address the federal prohibitions against discrimination in the purchase of mortgages.

OFHEO recommended that Fannie Mae develop formal guidance that addresses the

Enterprise’s compliance with the prohibition

against discrimination in any manner in the

purchase of mortgages set forth in section

1325(1) of the Act.

Results and Conclusions:

Freddie Mac

Overall, Freddie Mac’s management of business

risk, as it relates to the single-family business,

is generally strong. Management has effectively

identified the primary sources of business risk

and measured the potential adverse impact of

business risk in the single-family business.

Management consistently monitors and reports

to the board of directors on specific strategies

that have been developed to respond to sources

of business risk. Management has established a

system of internal controls to ensure that the

design and implementation of strategies are

consistent with corporate goals and objectives.

Certain aspects of Freddie Mac’s management
OFHEO 1997 Report to Congress 37

of business risk, however, can be improved.

Such enhancements to Freddie Mac’s risk

management can be made in the normal course

of business.

Freddie Mac’s management of business risk

from changes in the mortgage finance industry

structure is strong. Management has identified

this as a primary source of business risk in the

single-family business and has responded with

specific strategies, including process improvement initiatives. Management has appropriately implemented those strategies. Corporate

strategies are supported by specific operating

objectives that include defined management

responsibility and accountability. Management

monitors and prepares regular and special

reports for the board of directors on the market

environment, industry trends, and customer

satisfaction.

Freddie Mac’s management of business risk

associated with the new product development

process is adequate. The board of directors and

management have identified business risk

associated with new products and services and

developed formal processes, initiatives, and

operating procedures that facilitate achievement of corporate strategies and assist the

Enterprise in addressing industry, market, and

customer needs. Risk management processes

and internal controls associated with the design

and implementation strategies for new products

and services are generally effective, but can be

improved. Management closely monitors and

reports to the board of directors and senior

management on the progress of all new product

development initiatives. OFHEO recommended

that Freddie Mac enhance the quality control

processes for new products and services.

Freddie Mac’s management of business risk

from changes in its home mortgage delivery

system is strong. Management effectively

identifies and measures potential business risk

exposure associated with the use of its automated underwriting system. Freddie Mac has

developed an appropriate strategy for the

development and implementation of automated

underwriting that is focused on sound credit

risk management and process improvement.

Internal control processes have also been appropriately established that mitigate this source of

business risk. Management closely monitors

and reports to the board of directors on the

significant performance characteristics related

to Freddie Mac’s automated underwriting

system.

Freddie Mac’s process for managing the business risk from failure to comply with laws and

regulations is adequate. Freddie Mac’s integrated approach to compliance ensures that

business unit management and operating

committees are kept informed of and are able to

resolve compliance issues as they arise. Freddie

Mac has designed its compliance efforts to

address the federal prohibitions against discrimination in the purchase of mortgages.

OFHEO recommended that Freddie Mac augment its formal guidance by developing a policy

that addresses the Enterprise’s compliance with

the prohibition against discrimination in any

manner in the purchase of mortgages set forth

in section 1325(1) of the Act. OFHEO also

recommended that Freddie Mac complete the

work already in progress to document internal

policies and procedures related to

management’s self-assessment of risk in compliance-related areas.

Information Systems and

Technology (IT) Risk

Examination

In the spring of 1997, OFHEO initiated examinations of each Enterprise to assess the quantity of risk exposure and the quality of risk

management processes relating to information

systems and technology (IT) risk. IT risk is the

potential that an event or action will impair the

Enterprise’s ability to process operational and

financial information in a timely and accurate

manner.

The sources of IT risk include the degree of

reliance on IT, the management and retention

of IT skills and resources, the reliability or

effectiveness of IT systems and services, the
38 OFHEO 1997 Report to Congress

dynamic nature of the IT environment, the

degree of utilization of external IT resources,

and the degree of integration of business and IT

strategies.

The IT Risk Examination will evaluate the

adequacy of the risk management framework

for the information systems and technology

environments. The examinations will focus on

the effectiveness of management’s processes to

identify sources of risk, measure the level of

risk exposure, implement risk controls, and

monitor risk exposures.

“Year 2000”

The ability of computer systems and technology

to recognize and to process accurately date

sensitive information when the year changes to

2000 represents a critical component of information systems and technology risk. Computer

systems and technology that fail to recognize

and to process accurately dates in the next

century (“Year 2000”) could generate erroneous

data or could fail to process business transactions. OFHEO has established a three-part

approach to ensure that Fannie Mae and

Freddie Mac are adequately addressing “Year

2000” issues.

First, OFHEO has forwarded to the Enterprises

interagency standards for financial institutions

to address the “Year 2000” issues. On May 27,

1997, OFHEO issued letters to each of the

Enterprises transmitting the Federal Financial

Institutions Examination Council’s (FFIEC)

recently-issued interagency statement entitled

“Year 2000.” This statement represents an

interagency effort to make financial institutions

aware of the potential problem and to outline

examination procedures that will be utilized to

evaluate the status of this potential problem.

Second, the Office of Examination and Oversight has commenced initial “Year 2000” examination procedures as a part of the Information

Systems and Technology Risk Examinations.

These procedures have included briefings from

the Enterprises on plans and schedules for

addressing “Year 2000” issues.

Third, OFHEO has established a process to

routinely monitor and to assess the Enterprises’

progress in implementing plans and in achieving objectives relating to “Year 2000” programs.

OFHEO also is actively participating in the

FFIEC subcommittee on Information Systems

Examination to remain fully informed on issues

pertaining to “Year 2000” and on interagency

examination procedures to ensure safe and

sound information systems and technology.

Executive Compensation Authority

OFHEO’s enabling statute and the Enterprises’

Charter Acts gives the Director of OFHEO

oversight responsibility in the area of executive

compensation. OFHEO’s statute requires the

Director to prohibit the Enterprises from providing excessive compensation to any executive

officer. Specifically, the statute provides that

compensation must be reasonable and comparable with compensation paid by other similar

businesses to executives having similar duties

and responsibilities. “Similar businesses”

include publicly-held financial institutions or

major financial services companies. Additionally, the Enterprises’ Charter Acts require the

Enterprises to obtain prior approval of

OFHEO’s Director before entering into or

changing termination agreements with their

executive officers. The Charter Acts provide

that the Director of OFHEO may not approve

any such agreement unless the Director determines that the benefits provided under the

agreement are comparable to benefits provided

under such agreements for officers of other

public and private entities involved in financial

services and housing interests who have comparable duties and responsibilities.
OFHEO 1997 Report to Congress 39

OFHEO Finance and Administration

OFHEO is funded in much the same way as the

other federal financial regulators. That is, the

regulatees themselves, rather than the taxpayer, underwrite the costs associated with

their own regulation. In OFHEO’s case, operations are funded by semiannual assessments of

Fannie Mae and Freddie Mac. These assessments are prorated in proportion to each

Enterprise’s combined assets and mortgagebacked securities. Though not funded by the

taxpayer, OFHEO’s budget is, nonetheless,

subject to review and approval of the congressional appropriations process.

OFHEO’S budget for FY 1997 (the fiscal year

beginning Oct. 1, 1996) is $15.5 million. Activities covered by this budget include continued

development of the stress test, including a

working version of the financial simulation

model; ongoing examinations of Fannie Mae

and Freddie Mac; rulemaking activities; and

strengthening of OFHEO’s infrastructure. The

FY 1997 budget supports a staff of 72 full-time

permanent employees.

OFHEO’s recruiting and hiring policy continues

to reflect a commitment to professional excellence, integrity and diversity. At the start of FY

1997, 57 percent of OFHEO’s permanent staff

were women or minorities. Among senior staff,

56 percent were women or minorities.

Activities

OFHEO has engaged in a number of activities

to carry out the Director’s executive compensation responsibilities in the past 12 months. On

Sept. 26, 1996, OFHEO awarded a contract to

an executive compensation consulting firm to

assist the Office in developing further executive

compensation expertise. The compensation

consultant is helping OFHEO conduct a study

comparing current components and levels of

compensation of executive officers at the Enterprises with those of executive officers in other

similar businesses involving similar duties and

responsibilities. When the study is completed,

the consultant will assist OFHEO in implementing an ongoing review of the Enterprises’

executive compensation. This includes a comprehensive review and evaluation of termination agreements and severance benefits.

Since the publication of OFHEO’s 1996 Annual

Report to Congress, the Director has approved

the following agreements submitted by the

Enterprises: one severance package for a

departing executive officer and three termination agreements with executive officers who are

current employees. One request for approval of

a termination agreement for an executive

officer, recently submitted by an Enterprise, is

currently pending review by the Director. Until

OFHEO completes its review of executive

compensation issues, the approval of individual

termination or severance packages does not set

precedent on any particular issue.
Table 1: Fannie Mae: Balance Sheet / MBS (1971-1996)

Table 2: Fannie Mae: Capital / Earnings (1971-1996)

Table 3: Fannie Mae: Mortgage Asset Quality / Purchases (1971-1996)

Table 4: Fannie Mae: Business Activity: MBS (1980-1996)

Table 5: Freddie Mac: Balance Sheet / MBS (1971-1996)

Table 6: Freddie Mac: Capital / Earnings (1971-1996)

Table 7: Freddie Mac: Mortgage Asset Quality / Purchases (1971-1996)

Table 8: Freddie Mac: Business Activity: MBS (1971-1996)

Table 9: Aggregate Enterprise Financial Data (1971-1996)

Table 10: Aggregate Enterprise Financial Data (1971-1996)

Table 11: Aggregate Enterprise Financial Data (1971-1996)

Table 12: Mortgage Interest Rates (1972-1996)

Table 13: Housing Market Activity (1971-1996)

Table 14: Weighted Repeated Sales House Price Index (1976-1996)

Historical Data Tables
42

Source: Fannie Mae

*Note: Figures are not restated for 12/87 FAS 91 change.

1/ Gross Retained Portfolio net of unamortized purchase premiums, discounts, and fees.

2/ Excludes MBS held in portfolio.

3/ Includes Multiclass MBS held in portfolio.

Balance Sheet / MBS

Total

Assets

Retained Mortgage

Portfolio

Outstanding 1/

Debt

Outstanding

Multiclass

MBS

Outstanding 3/

Total MBS

Outstanding

2/

Fannie Mae Financial Data

Table 1

1Q97

4Q96

3Q96

2Q96

1Q96

($ in millions)

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979*

1978*

1977*

1976*

1975*

1974*

1973*

1972*

1971*

357,010

351,041

338,534

326,910

325,139

351,041

316,550

272,508

216,979

180,978

147,072

133,113

124,315

112,258

103,459

99,621

99,076

87,798

78,383

72,981

61,578

57,879

51,300

43,506

33,980

32,393

31,596

29,671

24,318

20,346

18,591

291,713

286,527

277,269

269,429

261,492

286,527

252,868

220,815

190,169

156,260

126,679

114,066

107,981

100,099

93,665

94,123

94,609

84,135

75,247

69,356

59,629

55,589

49,777

42,103

33,252

31,775

30,820

28,666

23,589

19,652

17,886

336,174

331,270

319,153

308,352

306,815

331,270

299,174

257,230

201,112

166,300

133,937

123,403

116,064

105,459

97,057

93,563

93,985

83,719

74,594

69,614

58,551

54,880

48,424

40,985

31,890

30,565

29,963

28,168

23,003

19,239

17,672

554,109

548,173

543,580

537,284

521,063

548,173

513,230

486,345

471,306

424,444

355,284

288,075

216,512

170,097

135,734

95,568

54,552

35,738

25,121

14,450

717

351,791

339,798

331,368

336,584

344,725

339,798

353,528

378,733

381,865

312,369

224,806

127,278

64,826

26,660

11,359

Annual Data
43

*Note: Figures are not restated for 12/87 FAS 91 change.

1/ Effective 1/1/95 reserves exclude valuation allowance related to impaired loans pursuant to SFAS 114.

2/ Taxable equivalent net interest income divided by average earning assets.

1Q97

4Q96

3Q96

2Q96

1Q96

Stockholders’

Equity

Equity /

(Assets +

MBS) (%)

(Equity + Loss

Reserves) /

(Assets + MBS)

(%) 1/

Net

Income

Net

Interest

Margin (%)

2/

Average

Guarantee

Fee Rate

(%)

Return on

Average

Common

Equity (%)

Not Applicable

Before 1981

13,178

12,773

12,267

11,751

11,379

12,773

10,959

9,541

8,052

6,774

5,547

3,941

2,991

2,260

1,811

1,182

1,009

918

1,000

953

1,080

1,457

1,501

1,362

1,173

983

861

772

680

559

460

1.45

1.42

1.39

1.36

1.34

1.42

1.32

1.26

1.17

1.12

1.10

0.94

0.88

0.80

0.76

0.61

0.66

0.74

0.97

1.09

1.73

2.49

2.93

3.13

3.45

3.03

2.73

2.60

2.80

2.75

2.47

1.53

1.50

1.48

1.45

1.44

1.50

1.41

1.37

1.29

1.25

1.24

1.06

1.01

0.94

0.90

0.74

0.76

0.85

1.10

1.25

1.90

2.73

3.17

3.36

3.66

3.19

2.84

2.69

2.87

2.78

2.49

734

712

691

668

654

2,725

2,144

2,132

1,873

1,623

1,363

1,173

807

507

376

105

(7)

(71)

49

(192)

(206)

14

162

209

165

127

115

107

126

96

61

1.17

1.17

1.17

1.18

1.20

1.18

1.16

1.24

1.38

1.37

1.42

1.39

1.16

0.89

1.00

0.40

0.15

(0.11)

(0.01)

(0.72)

(0.74)

0.04

0.70

0.98

0.95

0.82

0.73

0.70

0.98

0.84

0.40

0.227

0.226

0.225

0.223

0.223

0.224

0.220

0.225

0.213

0.212

0.210

0.211

0.213

0.216

0.224

0.238

0.256

0.262

0.263

0.272

0.250

24.0

24.2

24.5

24.0

23.8

24.1

20.9

24.3

25.3

26.5

27.7

33.7

31.1

25.2

23.5

9.5

(0.7)

(7.4)

5.1

(18.9)

(17.2)

0.9

11.3

16.5

15.3

13.8

14.1

14.7

20.3

18.8

14.4

Annual Data

Capital Earnings

Fannie Mae Financial Data

Table 2

($ in millions)

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980*

1979*

1978*

1977*

1976*

1975*

1974*

1973*

1972*

1971*
44

1Q97

4Q96

3Q96

2Q96

1Q96

ChargeOffs/

(Portfolio +

MBS) (%)

REO/

(Portfolio

+MBS) (%)

Annual Data

Mortgage Asset Quality Business Activity: Purchases

Fannie Mae Financial Data

Table 3

($ in millions)

Multifamily

Delinquency

Rate (%)

SingleFamily

Mortgage

Purchases

Mortgage

Securities

Purchased

2/

Multifamily

Mortgage

Purchases

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986#

1985#

1984#

1983#

1982#

1981#

1980#

1979*

1978*

1977*

1976*

1975*

1974*

1973*

1972*

1971*

0.59

0.58

0.56

0.56

0.58

0.58

0.56

0.47

0.48

0.53

0.64

0.58

0.69

0.88

1.12

1.38

1.48

1.65

1.49

1.41

0.96

0.90

0.56

0.55

0.46

1.58

0.56

0.51

0.58

0.68

0.91

1.00

0.95

Not Available

Before 1988

0.68

0.81

1.21

2.34

2.65

3.62

1.70

3.20

6.60

0.05

0.05

0.05

0.06

0.06

0.05

0.05

0.06

0.04

0.04

0.04

0.06

0.07

0.11

0.11

0.12

0.13

0.09

0.05

0.01

0.01

0.01

0.02

0.02

0.02

0.03

0.03

0.02

0.00

0.02

0.01

SingleFamily

Delinquency

Rate (%) 1/

Total

Mortgage

Purchases

Not Available

Before 1974

0.11

0.11

0.11

0.10

0.10

0.11

0.08

0.10

0.10

0.09

0.07

0.09

0.14

0.15

0.18

0.22

0.32

0.33

0.35

0.20

0.13

0.09

0.11

0.18

0.26

0.27

0.51

0.52

0.61

0.98

0.59

34,149

34,818

36,987

51,458

43,266

166,529

127,824

164,619

303,071

262,056

144,517

116,496

87,446

73,808

82,277

89,515

43,959

29,161

30,757

29,077

6,828

8,074

10,798

12,302

4,650

3,337

3,646

4,746

4,170

2,596

2,742

1,367

1,876

2,013

1,574

1,479

6,942

5,194

3,840

4,135

2,956

3,204

3,181

4,836

4,180

1,483

1,877

1,200

1,106

140

9

2

27

9

3

134

295

674

2,273

2,082

1,268

1,298

35,516

36,694

39,000

53,032

44,745

173,471

133,018

168,459

307,206

265,012

147,721

119,677

92,282

77,988

83,760

91,392

45,159

30,267

30,897

29,086

6,830

8,101

10,807

12,305

4,784

3,632

4,320

7,019

6,252

3,864

4,040

8,361

12,198

10,902

10,429

11,487

45,016

34,036

24,552

6,275

4,930

2,384

977

*Note: Asset Quality figures are not restated for 12/87 FAS 91 change.

#Note: Charge-off ratio has not been restated for change in Loss Accounting methodology.

1/ Single-family delinquency rate has been restated for periods prior to December 31, 1995, to include loans three

or more months delinquent or in foreclosure.

2/ Not included in mortgage purchases.
45

1Q97

4Q96

3Q96

2Q96

1Q96

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

($ in millions) Business Activity: MBS

Single-Family

MBS Issued

Multifamily

MBS Issued

Multiclass

MBS Issued

Annual Data

29,754

30,145

32,069

44,674

37,313

144,201

106,269

128,385

220,485

193,187

111,488

96,006

66,489

51,120

62,067

60,017

23,142

13,087

13,214

13,970

717

1,127

1,529

1,775

1,307

1,057

5,668

4,187

2,237

959

850

1,415

689

3,275

3,758

1,162

549

507

459

126

30,881

31,674

33,844

45,981

38,370

149,869

110,456

130,622

221,444

194,037

112,903

96,695

69,764

54,878

63,229

60,566

23,649

13,546

13,340

13,970

717

19,559

16,884

5,589

5,546

2,760

30,779

9,681

73,365

210,630

170,205

112,808

68,291

41,715

17,005

9,917

2,400

Fannie Mae Financial Data

Table 4

Total MBS

Issued
46

Total Assets Retained Mortgage

Portfolio

Outstanding 1/

Debt

Outstanding

2/

Multiclass

MBS

Outstanding

Total MBS

Outstanding

3/

1Q97

4Q96

3Q96

2Q96

1Q96

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

174,442

173,866

162,984

160,750

143,792

173,866

137,181

106,199

83,880

59,502

46,860

40,579

35,462

34,352

25,674

23,229

16,299

13,175

8,954

6,029

6,326

5,478

4,648

3,697

3,501

4,832

5,899

4,901

2,873

1,778

1,038

144,672

137,826

129,518

123,929

117,644

137,826

107,706

73,171

55,938

33,629

26,667

21,520

21,448

16,918

12,354

13,093

13,547

10,018

7,485

4,679

5,178

5,006

4,003

3,038

3,204

4,175

4,878

4,469

2,521

1,726

935

153,124

156,491

146,472

142,739

123,637

156,491

119,328

92,053

48,510

28,173

28,300

28,375

24,102

24,846

17,461

13,378

11,754

10,186

6,782

4,521

5,480

4,686

3,981

3,066

3,110

3,351

4,050

3,989

2,696

1,639

915

473,405

473,065

471,310

467,533

461,189

473,065

459,045

460,656

439,029

407,514

359,163

316,359

272,870

226,406

212,635

169,186

99,908

70,025

57,720

42,952

19,897

16,962

15,316

12,017

6,765

2,765

1,643

780

791

444

64

253,191

237,630

235,432

238,123

247,013

237,630

246,969

263,662

264,122

217,030

142,960

83,437

47,573

10,877

($ in millions) Balance Sheet/ MBS

Freddie Mac Financial Data

Table 5

Source: Freddie Mac

1/ Gross Retained Portfolio net of unamortized purchase premiums, discounts, and fees. Beginning 1/1/95, the data reflects adoption of

SFAS 114. Data for prior periods have not been restated.

2/ Does not include subordinated borrowings.

3/ Excludes MBS held in portfolio.

Annual Data
47

1Q97

4Q96

3Q96

2Q96

1Q96

Stockholders’

Equity

Equity /

(Assets +

MBS) (%)

(Equity + Loss

Reserves) /

(Assets + MBS)

(%) 1/

Net

Income

2/

Net

Interest

Margin (%)

2/ 3/ 4/ 5/

Average

Guarantee

Fee Rate

(%) 3/

Return on

Average

Common

Equity (%)

Not Available

Annual Data

($ in millions) Capital Earnings

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

1/ Effective 1/1/95 reserves exclude valuation allowance related to impaired loans pursuant to SFAS 114. Valuation allowance estimated for 1Q97.

2/ Effective January 1, 1996, Freddie Mac reports guarantee fees on retained MBS as guarantee fee income. Previously these fees were included in net interest

income. However, for comparability with Fannie Mae, guarantee fee income on retained MBS for the first quarter have been estimated and included in the net

interest income.

3/ 1993 and 1992 are pro forma, to reflect the change in the reporting of uncollectible interest on single-family mortgages implemented in 1994.

4/ Average balances used in pre-1987 calculations are based on the simple average of the year-end balance of the reported period and the prior year-end balance.

Subsequent calculations use daily average balances.

5/ Beginning with 1993 data, net interest margin is calculated on a taxable equivalent basis.

Freddie Mac Financial Data

Table 6

6,811

6,731

6,500

6,407

6,012

6,731

5,863

5,162

4,437

3,570

2,566

2,136

1,916

1,584

1,182

953

779

606

421

296

250

221

238

202

177

156

142

126

121

110

107

1.05

1.04

1.02

1.02

0.99

1.04

0.98

0.91

0.85

0.76

0.63

0.60

0.62

0.61

0.50

0.50

0.67

0.73

0.63

0.60

0.95

0.98

1.19

1.29

1.72

2.05

1.88

2.22

3.30

4.95

9.71

1.16

1.13

1.13

1.13

1.11

1.13

1.09

1.04

0.99

0.93

0.81

0.77

0.77

0.76

0.64

0.64

0.86

0.95

0.85

0.84

1.30

1.31

1.49

1.56

2.02

2.34

2.24

2.52

3.71

5.18

Not Available

329

321

312

309

301

1,243

1,091

983

786

622

555

414

437

381

301

247

208

144

160

60

31

34

36

25

21

14

16

5

12

4

6

1.15

1.10

1.09

1.16

1.25

1.15

1.23

1.25

1.02

1.17

1.66

1.76

1.62

1.95

1.50

1.66

2.31

2.08

1.83

0.53

0.63

1.17

1.45

1.11

0.77

0.34

0.58

1.09

1.35

Not Available

Before 1973

0.230

0.232

0.233

0.234

0.235

0.234

0.238

0.241

0.238

0.241

0.237

0.224

0.234

0.215

0.242

0.224

0.221

0.247

0.262

0.245

0.195

0.143

0.132

0.149

0.189

0.136

0.248

0.255

0.324

0.394

22.6

22.2

21.8

22.4

22.4

22.1

21.9

23.2

22.2

21.2

23.6

20.5

25.0

27.6

28.2

28.5

30.0

52.0

44.5

21.9

13.1

14.7

16.2

13.4

12.4

9.5

11.6

4.0

9.9

3.5

5.5
48

1Q97

4Q96

3Q96

2Q96

1Q96

ChargeOffs/

(Portfolio +

MBS) (%)

REO/

(Portfolio

+MBS) (%)

3/

Annual Data

Mortgage Asset Quality Business Activity: Purchases

Freddie Mac Financial Data

Table 7

($ in millions)

Multifamily

Delinquency

Rate (%) 2/

SingleFamily

Mortgage

Purchases

Mortgage

Securities

Purchased

4/

Multifamily

Mortgage

Purchases

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

Not Applicable

Before 1982

SingleFamily

Delinquency

Rate (%) 1/

Total

Mortgage

Purchases

Not Available

Before 1978

1/ Pre-1982 delinquencies apply to the retained and sold mortgage portfolios.

2/ 1988-1994 MF delinquencies based on unpaid principal balance. 1982-1987 MF delinquencies based on the number of loans

delinquent 60 days or more.

3/ Beginning with 1Q95, data includes adoption of SFAS 114. Prior periods not restated.

4/ Not Included in mortgage purchases.

* Estimated

0.60

0.58

0.57

0.58

0.60

0.58

0.60

0.55

0.61

0.64

0.61

0.45

0.38

0.36

0.36

0.42

0.42

0.46

0.47

0.54

0.61

0.44

0.31

0.21

1.88

1.96

2.89

3.14

2.75

1.96

2.88

3.79

3.45

4.45

3.40

2.63

2.53

2.24

1.49

1.07

0.63

0.42

0.58

1.04

Not Available

Before 1985

Not Available

Before 1985

Not Available

Before 1973

0.09

0.10

0.10

0.11

0.10

0.10

0.10

0.08

0.05

0.06

0.08

0.08

0.06

0.06

0.06

0.04

0.04

0.02

0.02

0.01

0.00

0.04

0.02

0.00

0.00

0.03

0.05

0.70

0.36

Not Available

Before 1973

0.12

0.13

0.13

0.13

0.14

0.13

0.14

0.18

0.20

0.17

0.14

0.12

0.09

0.09

0.08

0.07

0.10

0.15

0.13

0.12

0.07

0.04

0.02

0.02

0.03

0.04

0.03

0.02

0.00

24,124

26,784

27,431

34,456

34,179

122,850

89,971

122,563

229,051

191,099

99,729

74,180

76,765

42,884

74,824

99,936

42,110

373

1,232

367

284

346

2,229

1,565

847

191

27

236

1,338

1,824

1,191

2,016

3,538

1,902

24,497

28,016

27,798

34,740

34,525

125,079

91,536

123,410

229,242

191,126

99,965

75,518

78,589

44,075

76,840

103,474

44,012

21,885

22,952

23,671

3,744

3,690

5,716

6,524

4,124

1,129

1,716

2,185

1,334

1,265

778

7,617

8,663

6,466

9,378

11,706

36,213

39,850

19,836

9,947*

6,394*
49

1Q97

4Q96

3Q96

2Q96

1Q96

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

($ in millions)

Single-Family

MBS Issued

Multifamily

MBS Issued

Multiclass

MBS Issued

Annual Data

Total MBS

Issued

Business Activity: MBS

26,271

25,716

26,644

33,831

32,741

118,932

85,522

116,901

208,724

179,202

92,479

71,998

72,931

39,490

72,866

96,798

37,583

0

757

13

0

0

770

355

209

0

5

0

1,817

587

287

2,152

3,400

1,245

26,271

26,473

26,657

33,831

32,741

119,702

85,877

117,110

208,724

179,207

92,479

73,815

73,518

39,777

75,018

100,198

38,828

18,684

19,691

24,169

3,529

2,526

4,546

6,412

4,657

1,360

950

46

323

494

65

22,181

8,335

15,247

5,410

5,153

Freddie Mac Financial Data

Table 8

34,145

15,372

73,131

143,336

131,284

72,032

40,479

39,754

12,985

Not Available

Before 1985

Not Available

Before 1985
50

Total Assets Retained Mortgage

Portfolio

Outstanding

Debt

Outstanding

Multiclass

MBS

Outstanding

Total MBS

Outstanding

1Q97

4Q96

3Q96

2Q96

1Q96

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

($ in millions) Balance Sheet/ MBS

Annual Data

531,452

524,907

501,518

487,660

468,931

524,907

453,731

378,707

300,859

240,480

193,932

173,692

159,777

146,610

129,133

122,850

115,375

100,973

87,337

79,010

67,904

63,357

55,948

47,203

37,481

37,225

37,495

34,572

27,191

22,124

19,629

436,385

424,353

406,787

393,358

379,136

424,353

360,574

293,986

246,107

189,889

153,346

135,586

129,429

117,017

106,019

107,216

108,156

94,153

82,732

74,035

64,807

60,595

53,780

45,141

36,456

35,950

35,698

33,135

26,110

21,378

18,821

489,298

487,761

465,625

451,091

430,452

487,761

418,502

349,283

249,622

194,473

162,237

151,778

140,166

130,305

114,518

106,941

105,739

93,905

81,376

74,135

64,031

59,566

52,405

44,051

35,000

33,916

34,013

32,157

25,699

20,878

18,587

1,027,514

1,021,238

1,014,890

1,004,817

982,252

1,021,238

972,275

947,001

910,335

831,958

714,447

604,434

489,382

396,503

348,369

264,754

154,490

105,763

82,841

57,402

20,614

16,962

15,316

12,017

6,765

2,765

1,643

780

791

444

64

604,982

577,428

566,800

574,707

591,738

577,428

600,000

642,395

645,987

529,399

367,766

210,715

112,399

37,537

11,359

Aggregate Financial Data

Table 9
51

1Q97

4Q96

3Q96

2Q96

1Q96

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

($ in millions)

Stockholders’

Equity

Equity/

(Assets +

MBS) (%)

Net Income

Annual Data

(Equity + Loss

Reserves) /

(Assets + MBS)

(%)

Capital Earnings

19,989

19,504

18,767

18,158

17,391

19,504

16,822

14,703

12,489

10,344

8,113

6,077

4,907

3,844

2,993

2,135

1,788

1,524

1,421

1,249

1,330

1,678

1,739

1,564

1,350

1,139

1,003

898

801

669

567

1.28

1.26

1.24

1.22

1.20

1.26

1.18

1.11

1.03

0.96

0.89

0.78

0.76

0.71

0.63

0.55

0.66

0.74

0.84

0.92

1.50

2.09

2.44

2.64

3.05

2.85

2.56

2.54

2.86

2.96

2.88

1.37

1.36

1.33

1.32

1.30

1.36

1.28

1.23

1.16

1.11

1.05

0.93

0.90

0.85

0.77

0.69

0.80

0.89

1.00

1.10

1.72

2.33

2.70

2.88

3.28

3.03

2.72

2.66

2.98

3.02

1,603

1,033

1,003

977

955

3,968

3,235

3,115

2,659

2,245

1,918

1,587

1,244

888

677

352

201

73

209

(132)

(175)

48

198

234

186

141

131

112

138

100

67

Aggregate Financial Data

Table 10

Not Available
52

Aggregate Financial Data

Table 11

1Q97

4Q96

3Q96

2Q96

1Q96

Total

MBS

Issued

Multiclass

MBS

Issued

Annual Data

($ in millions) Business Activity: Purchases Business Activity: MBS

Multifamily

MBS

Issued

SingleFamily

Mortgage

Purchases

Mortgage

Securities

Purchased

Multifamily

Mortgage

Purchases

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

SingleFamily

MBS

Issued

Total

Mortgage

Purchases

1/ Pre-1982 delinquencies apply to the retained and sold mortgage portfolios.

2/ 1988-1994 MF delinquencies based on unpaid principal balance. 1982-1987 MF delinquencies based on the number of loans

delinquent 60 days or more.

3/ Beginning with 1Q95, data includes adoption of SFAS 114. Prior periods not restated.

4/ Included in mortgage purchases.

58,273

61,602

64,418

85,914

77,445

1,740

3,108

2,380

1,858

1,825

60,013

64,710

66,798

87,772

79,270

15,978

20,861

17,368

19,807

23,193

56,025

55,861

58,713

78,505

70,054

1,127

2,286

1,788

1,307

1,057

57,152

58,147

60,501

79,812

71,111

41,740

25,219

20,836

10,956

7,913

Freddie Mac

Not Available

Before 1985

289,379

217,795

287,182

532,122

453,155

244,246

190,676

164,211

116,692

157,101

189,451

86,069

9,171

6,759

4,687

4,326

2,983

3,440

4,519

6,660

5,371

3,499

5,415

3,102

Freddie Mac

Not Available

Before 1985

298,550

224,554

291,869

536,448

456,138

247,686

195,195

170,871

122,063

160,600

194,866

89,171

52,152

53,849

52,757

10,574

11,791

16,523

18,829

8,908

4,761

6,036

9,204

7,586

5,129

81,229

73,886

44,388

16,222

11,324

8,778

977

263,133

191,791

245,286

429,209

372,389

203,967

168,004

139,420

90,610

134,933

156,815

60,725

Freddie Mac

Not Available

Before 1985

Freddie Mac

Not Available

Before 1985

6,438

4,542

2,446

959

855

1,415

2,506

3,862

4,045

3,314

3,949

1,752

269,571

196,333

247,732

430,168

373,244

205,382

170,510

143,282

94,655

138,247

160,764

62,477

32,230

33,031

38,139

4,246

2,526

4,546

6,412

4,657

1,360

950

46

323

494

65

64,924

25,053

146,496

353,966

301,489

184,840

108,770

81,469

29,740

9,917

2,400
53

Mortgage Interest Rates

Table 12

7.8

7.7

8.2

8.1

7.2

1Q97

4Q96

3Q96

2Q96

1Q96

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

7.8

7.9

8.4

7.3

8.4

9.2

10.1

10.3

10.3

10.2

10.2

12.4

13.9

13.2

16.0

16.6

13.7

11.2

9.6

8.8

8.9

9.0

9.2

8.0

7.4

5.6

5.6

5.9

5.8

5.4

5.7

6.1

5.4

4.6

5.6

7.1

8.4

8.8

7.9

7.8

8.4

10.0

11.5

Not Applicable

Before1984

8.0

8.1

8.4

8.1

7.4

8.0

8.3

8.2

7.5

8.5

9.7

10.4

10.5

10.4

9.9

10.5

12.4

13.2

13.0

15.2

Not Available

Before1982

7.0

6.9

7.2

7.1

6.9

7.0

7.1

6.4

5.7

6.6

8.3

9.2

9.4

8.5

8.5

9.4

10.9

12.1

12.3

15.4

Not Applicable

Before1982

Average Commitment

Rates on Loans

Effective Rates on Closed

Loans

Annual Data

Conventional Conventional

30 Year

Fixed Rate

(%)

One Year

ARMs(%)

Fixed Rate

(%)

Adjustable

Rate (%)

Average Commitment Rate Source: Freddie Mac

Effective Rates Source: Federal Housing Finance Board
54

Housing Market Activity

Table 13

1Q97

4Q96

3Q96

2Q96

1Q96

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

1,193

1,142

1,220

1,240

1,187

1,206

1,110

1,234

1,155

1,061

876

932

1,059

1,140

1,212

1,263

1,166

1,206

1,181

743

796

962

1,316

1,558

1,573

1,248

956

956

1,250

1,451

1,271

248

273

272

255

278

271

244

224

133

139

138

260

318

348

409

542

576

544

522

320

288

331

429

462

414

289

204

382

795

906

781

1,441

1,415

1,492

1,495

1,465

1,477

1,354

1,457

1,288

1,200

1,014

1,193

1,376

1,488

1,621

1,805

1,742

1,750

1,703

1,062

1,084

1,292

1,745

2,020

1,987

1,538

1,160

1,338

2,045

2,357

2,052

824

763

788

735

739

757

667

670

666

610

509

534

650

676

671

750

688

639

623

412

436

545

709

817

819

646

549

519

634

718

656

4,083

4,003

4,090

4,223

3,970

4,087

3,802

3,946

3.802

3,520

3,220

3,211

3,346

3,594

3,526

3,565

3,214

2,868

2,719

1,990

2,419

2,973

3,827

3,986

3,650

3,064

2,476

2,272

2,334

2,252

2,018

Housing Starts

Units in Thousands

Home Sales

Units in Thousands

SingleFamily

Housing

Starts

Multifamily

Housing

Starts

Total

Housing

Starts

New SingleFamily

Home Sales

Existing

SingleFamily

Home Sales

Components may not add to totals due to rounding.

Housing Starts Source: Bureau of the Census.

New Single-Family Home Sales Source: Bureau of the Census.

Existing Single-Family Home Sales Source: National Association of Realtors

Annual Data
55

Weighted Repeat Sales House Price Index

Table 14

1Q97

4Q96

3Q96

2Q96

1Q96

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

%

Change

USA New

England

MidAtlanticSouth

Atlantic

East

North

Central

West

North

Central

East

South

Central

West

South

Central

Mountain Pacific

Annual Data

3.1

3.6

3.3

4.6

5.7

3.6

5.2

1.4

2.3

1.9

2.6

0.4

6.0

6.2

7.4

9.4

6.4

4.0

3.1

3.1

3.8

5.7

11.8

12.6

12.5

8.2

1.7

2.5

1.7

3.6

5.5

2.5

5.1

-2.8

0.8

-0.9

-1.9

-7.8

0.9

4.0

12.3

19.2

22.1

16.6

14.4

4.9

5.9

5.1

12.1

14.6

9.9

2.3

0.4

1.1

1.0

2.8

5.0

1.1

3.7

-2.7

1.6

1.7

1.6

-2.3

2.5

6.2

16.0

18.0

11.9

12.1

9.6

4.1

-0.2

7.2

14.1

8.2

8.3

7.9

2.9

3.3

3.3

4.6

5.8

3.3

5.2

0.8

2.3

2.1

3.1

0.3

5.0

7.0

7.5

8.4

5.8

1.0

3.3

5.2

4.0

7.6

12.1

9.8

8.9

4.4

6.4

6.2

6.4

6.5

6.0

6.2

6.1

6.0

3.7

3.8

4.4

3.8

5.9

6.5

8.3

8.0

4.4

2.7

0.2

-0.8

0.7

1.2

9.2

13.9

12.8

7.8

4.7

5.1

5.2

5.6

5.6

5.1

5.4

6.2

3.9

3.0

3.7

0.7

3.2

2.7

3.8

5.9

3.1

4.6

3.5

0.3

0.0

2.9

8.7

11.9

13.1

5.5

4.8

5.3

4.8

6.1

6.6

5.4

6.2

5.1

4.1

3.5

4.0

0.7

3.3

2.9

4.9

8.7

11.1

-3.7

4.8

5.1

-1.9

2.6

6.1

9.8

9.7

9.5

2.1

2.7

2.8

4.4

5.8

2.7

5.0

1.7

4.2

3.5

3.7

0.8

3.0

-1.9

-8.5

0.9

-2.8

-1.1

-0.6

5.4

12.3

5.6

12.8

16.4

11.1

9.0

4.8

5.7

5.7

6.8

8.0

5.7

8.2

9.7

8.2

5.4

4.8

1.8

2.6

0.6

-0.9

4.4

1.0

0.6

-3.0

6.7

6.2

6.1

14.7

14.6

17.9

10.3

1.4

1.7

0.8

2.8

4.7

1.7

3.9

-3.3

-1.6

-1.1

1.6

2.9

17.9

15.8

9.5

7.2

4.5

4.5

0.9

0.8

6.4

11.0

15.5

15.3

23.0

18.6

Source: OFHEO

Regional Division: New England:

Mid-Atlantic:

South Atlantic:

East North Central:

West North Central:

East South Central:

West South Central:

Mountain:

Pacific:

CT, MA, ME, NH, RI, VT

NJ, NY, PA

DC, DE, FL, GA, MD, NC, SC, VA, WV

IL, IN, MI, OH, WI

IA, KS, MN, MO, ND, NE, SD

AL, KY, MS, TN

AR, LA, OK, TX

AZ, CO, ID, MT, NH, NV, UT, WY

AK, CA, HI, OR, WA

OFHEO 1997 Report to Congress 57

Appendix

Federal Housing Enterprises Financial Safety and Soundness Act of 1992

(Title XIII of Public Law 102-550)

Office of Federal Housing Enterprise Oversight

OFHEO Senior Officials

Index of Tables, Boxes and Figures
58 OFHEO 1997 Report to Congress

Section 1313. DUTY AND AUTHORITY OF DIRECTOR.

(a) DUTY. - The duty of the Director shall be to ensure that the enterprises are adequately

capitalized and operating safely, in accordance with this title.

(b) AUTHORITY EXCLUSIVE OF SECRETARY.- The Director is authorized, without the

review or approval of the Secretary, to make such determinations, take such actions, and perform

such functions as the Director determines necessary regarding -

(1) the issuance of regulations to carry out this part, subtitle B, and subtitle C (including the establishment of capital standards pursuant to subtitle B);

(2) examinations of the enterprises under section 1317;

(3) determining the capital levels of the enterprises and classification of the enterprises within capital classifications established under subtitle B;

(4) decisions to appoint conservators for the enterprises;

(5) administrative and enforcement actions under subtitle B, actions taken under

subtitle C with respect to enforcement of subtitle B, and other matters relating to safety and

soundness;

(6) approval of payments of capital distributions by the enterprises under section

303(c)(2) of the Federal National Mortgage Association Charter Act and section 303(b)(2) of

the Federal Home Loan Mortgage Corporation Act;

(7) requiring the enterprises to submit reports under section 1314 of this title, section

309(k) of the Federal National Mortgage Association Charter Act, and section 307(c) of the

Federal Home Loan Mortgage Corporation Act;

(8) prohibiting the payment of excessive compensation by the enterprises to any executive officer of the enterprises under section 1318;

(9) the management of the Office, including the establishment and implementation

of annual budgets, the hiring of, and compensation levels for, personnel of the Office, and

annual assessments for the costs of the Office;

(10) conducting research and financial analysis;

(11) the submission of reports required by the Director under this title.

(c) AUTHORITY SUBJECT TO APPROVAL OF SECRETARY.- Any determinations, actions,

and functions of the Director not referred to in subsection (b) shall be subject to the review and

approval of the Secretary.

(d) DELEGATION OF AUTHORITY.- The Director may delegate to officers and employees of

the Office any of the functions, powers, and duties of the Director, as the Director considers appropriate.

(e) INDEPENDENCE IN PROVIDING INFORMATION TO CONGRESS.- The Director shall

not be required to obtain the prior approval, comment, or review of any officer or agency of the

United States before submitting to the Congress, or any committee or subcommittee thereof, any

reports, recommendations, testimony, or comments if such submissions include a statement indicating that the views expressed therein are those of the Director and do not necessarily represent

the views of the Secretary or the President.

Federal Housing Enterprises Financial Safety

and Soundness Act of 1992

 (Title XIII of Public Law)
OFHEO 1997 Report to Congress 59

The Office of Federal Housing Enterprise Oversight (OFHEO) was established as an independent

entity within the Department of Housing and Urban Development by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (Title XIII of P.L. 102-550). The Office is headed by

a Director appointed by the President for a five-year term.

OFHEO’s primary mission is ensuring the capital adequacy and financial safety and soundness of

two government-sponsored enterprises (GSEs) — the Federal National Mortgage Association

(Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

Fannie Mae and Freddie Mac are the nation’s largest housing finance institutions. They buy mortgages from commercial banks, thrift institutions, mortgage banks, and other primary lenders, and

either hold these mortgages in their own portfolios or package them into mortgage-backed securities

for resale to investors. These secondary mortgage market operations play a major role in creating a

ready supply of mortgage funds for American homebuyers. Combined assets and off-balance sheet

obligations of Fannie Mae and Freddie Mac were $1.5 trillion at the end of 1996.

Fannie Mae and Freddie Mac are Congressionally chartered, publicly-owned corporations whose

shares are listed on the New York Stock Exchange. Under terms of their GSE charters, they are exempt from state and local taxation and from registration requirements of the Securities and Exchange

Commission. Each firm has a potential credit line with the U.S. Treasury.

OFHEO’s oversight responsibilities include:

· Conducting broad based examinations of Fannie Mae and Freddie Mac;

· Developing a risk-based capital standard, using a stress test, that simulates stressful interest

rate and credit risk scenarios;

· Making quarterly findings of capital adequacy based on a minimum capital standard and,

when completed, a risk-based standard;

· Prohibiting excessive executive compensation;

· Issuing regulations concerning capital and enforcement standards;

and

· Taking necessary enforcement actions.

OFHEO is funded through assessments of Fannie Mae and Freddie Mac. OFHEO’s operations represent no direct cost to the taxpayer.

In its safety and soundness mission, OFHEO has regulatory authority similar to such other federal

financial regulators as the Federal Deposit Insurance Corporation, the Office of the Comptroller of

the Currency, the Office of Thrift Supervision and the Board of Governors of the Federal Reserve

System.

(The legislation that established OFHEO also requires Fannie Mae and Freddie Mac to meet certain

affordable housing goals set annually by the Secretary of Housing and Urban Development. These

goals specify the share of mortgages that the two GSEs are required to purchase annually from lowincome, moderate-income and central-city homebuyers.)

Office of Federal Housing

Enterprise Oversight
60 OFHEO 1997 Report to Congress

Mark Kinsey

Acting Director

Office of Federal Housing Enterprise Oversight

Senior Officials

Eugene Carlson

Director for Public Affairs

Anne Dewey

General Counsel

Office of General Counsel

Susan Jacobs

Director

Office of Finance and Administration

Patrick Lawler

Chief Economist and

Director, Office of Policy Analysis

Thomas Loeffler

Acting Director

Office of Examination and Oversight

David Pearl

Director

Office of Research, Analysis

 and Capital Standards

Mary Ellen Taylor

Policy Advisor and

Director, Congressional Affairs
OFHEO 1997 Report to Congress 61

Index of Tables, Boxes and Figures

Tables

Table 1: How Prices Are Established in a Securitization Model................................................... 3

Table 2: Sample Mortgage Insurance Rate Sheet .......................................................................... 5

Table 3: The Impact of Credit Scores on Risk Rating .................................................................... 6

Table 4: Standard & Poor’s Risk Grades ........................................................................................ 7

Boxes

Box 1: Subprime Markets and the Blurring of the Conforming Market ................................... 9

Box 2: Structured Note Activity Increased in 1996................................................................... 23

Figures

Figure 1: Mortgage Interest Rates.................................................................................................. 11

Figure 2: OFHEO House Price Index (United States)

 Annual Percent Changes ................................................................................................. 12

Figure 3: One-Year Change in House Prices U.S. Census Divisions

 Fourth Quarter 1995 to Fourth Quarter 1996 .............................................................. 12

Figure 4: Originations of Single-Family Mortgages ...................................................................... 13

Figure 5: Refinance Share of Total Mortgage Originations vs. Commitment Rate on

 30-Year FRMs................................................................................................................... 13

Figure 6: ARM Share of Conventional Single-Family Loans vs. Commitment Rate on

 30-Year FRMs................................................................................................................... 14

Figure 7: Single-Family Originations by Lender ........................................................................... 14

Figure 8: Enterprises’ Single-Family Mortgage Purchases .......................................................... 14

Figure 9: Enterprises’ Share of Conventional Single-Family Mortgage Market ......................... 15

Figure 10: Proportion of Single-Family Mortgage Purchases with LTV Ratios

 Greater than 90% ............................................................................................................. 15

Figure 11: Enterprises’ Multifamily Mortgage Purchases .............................................................. 16

Figure 12: Enterprise Single-Class MBS Issuance.......................................................................... 16

Figure 13: Enterprise REMIC Issuances ......................................................................................... 17

Figure 14: Enterprises’ Primary Sources of Revenue ...................................................................... 17

Figure 15: Single-Family Delinquency Rates .................................................................................. 21

Figure 16: Enterprises’ Equity Capital as a Percent of Minimum Capital

 Requirements ................................................................................................................... 21