7468 Federal Register / Vol. 60, No. 26 / Wednesday, February 8, 1995 / Proposed Rules

1See section 306(h)(2), Federal Home Loan

Mortgage Corporation Act (12 U.S.C. 1455(h)(2))

and section 304(b), Federal National Mortgage

Association Charter Act (12 U.S.C. 1719(b)).

must be fully amortized by December

31, 1998. 12 CFR 35.3(b).

The OCC proposes to remove 12 CFR

part 35, effective January 1, 1999,

obviating the need for regulatory action

in the future. Prior to that date, an

annotation to part 35 in title 12 of the

Code of Federal Regulations would

indicate the effective date for removal of

the part.

Regulatory Flexibility Act

It is hereby certified that this

regulation will not have a significant

economic impact on a substantial

number of small entities. Accordingly, a

regulatory flexibility analysis is not

required. This regulation has no

material impact on national banks,

regardless of size.

Executive Order 12866

The OCC has determined that this

proposal is not a significant regulatory

action under Executive Order 12866.

Paperwork Reduction Act

The collection of information

contained in 12 CFR 35.7 has been

approved by the Office of Management

and Budget (OMB) under OMB Control

Number 1557–0186. This proposal

would remove as unnecessary, for the

reasons set forth in the preamble, that

collection of information effective

January 1, 1999. Comments on the

OCC’s proposed elimination of this

collection of information should be sent

to the Office of Management and

Budget, Paperwork Reduction Project

(1557–0186), Washington, DC 20503,

with a copy to the OCC’s Legislative and

Regulatory Activities Division (Attn:

1557–0186) at the OCC address

previously specified.

List of Subjects in 12 CFR Part 35

Accounting, Agriculture, National

banks, Reporting and recordkeeping

requirements.

Authority and Issuance

For the reasons set out in the

preamble, and under the authority of 12

U.S.C. 93a and 1823(j), chapter I of title

12 of the Code of Federal Regulations is

proposed to be amended as follows:

PART 35—[REMOVED]

1. Part 35 is removed effective January

1, 1999.

Dated: February 3, 1995.

Eugene A. Ludwig,

Comptroller of the Currency.

[FR Doc. 95–3117 Filed 2–7–95; 8:45 am]

BILLING CODE 4810–33–P

DEPARTMENT OF HOUSING AND

URBAN DEVELOPMENT

Office of Federal Housing Enterprise

Oversight

12 CFR Chapter XVII

RIN 2550–AA02

Risk-Based Capital

AGENCY: Office of Federal Housing

Enterprise Oversight, HUD.

ACTION: Advance Notice of Proposed

Rulemaking.

SUMMARY: Title XIII of the Housing and

Community Development Act of 1992,

known as the Federal Housing

Enterprises Financial Safety and

Soundness Act of 1992, gives the Office

of Federal Housing Enterprise Oversight

(OFHEO) the responsibility for

developing a risk-based capital

regulation for the Federal National

Mortgage Association and the Federal

Home Loan Mortgage Corporation

(collectively, the Enterprises). To

discharge this responsibility, OFHEO

must develop and implement a riskbased capital ‘‘stress test’’ that, when

applied to the Enterprises, determines

the amount of capital that an Enterprise

must hold initially to maintain positive

capital throughout a ten-year period of

economic stress.

This Advance Notice of Proposed

Rulemaking (ANPR) announces

OFHEO’s intention to develop and

publish a risk-based capital regulation

and solicits public comment on a

variety of issues prior to the publication

of a proposed rule. OFHEO requests

comment from the public concerning

issues set forth in the ‘‘Solicitation of

Public Comment’’ subsection of the

SUPPLEMENTARY INFORMATION section

below.

DATES: Comments regarding the ANPR

must be received in writing on or before

May 9, 1995.

ADDRESSES: Send written comments to

Anne E. Dewey, General Counsel, Office

of General Counsel, Office of Federal

Housing Enterprise Oversight, 1700 G

Street, NW, Fourth Floor, Washington,

D.C. 20552.

FOR FURTHER INFORMATION CONTACT:

David J. Pearl, Director, Research,

Analysis and Capital Standards; or Gary

L. Norton, Deputy General Counsel,

Office of Federal Housing Enterprise

Oversight, 1700 G Street, NW, Fourth

Floor, Washington, D.C. 20552,

telephone (202) 414–3800 (not a toll-free

number).

SUPPLEMENTARY INFORMATION:

Background

Title XIII of the Housing and

Community Development Act of 1992,

Pub. L. No. 102–550, known as the

Federal Housing Enterprises Financial

Safety and Soundness Act of 1992, 12

U.S.C. 4501 et seq. (Act), established the

Office of Federal Housing Enterprise

Oversight (OFHEO) as an independent

office within the Department of Housing

and Urban Development. OFHEO’s

primary function is to ensure the

financial safety and soundness and the

capital adequacy of the nation’s two

largest housing finance institutions—the

Federal National Mortgage Association

(Fannie Mae) and the Federal Home

Loan Mortgage Corporation (Freddie

Mac) (collectively, the Enterprises).

Fannie Mae and Freddie Mac are

Government-sponsored enterprises that

serve important public purposes and

receive significant financial benefits,

including exemption from state and

local income taxes and special treatment

of their securities in a variety of

regulatory and transactional situations.

Although the securities that they issue

or guarantee are not backed by the full

faith and credit of the United States,1

their status as Government-sponsored

enterprises creates, in the view of

financial market participants, an

implicit Federal guarantee of those

securities. Furthermore, the failure of

either of the Enterprises would have

serious consequences for the

performance of the nation’s housing

markets, with a potentially

disproportionate effect on low- and

moderate-income families.

The Enterprises engage in two

principal businesses. First, they

maintain a portfolio of residential

mortgages and, second, they issue and

guarantee pools of residential

mortgages—in the form of mortgagebacked securities (MBS)—that are held

by investors. One of the Enterprises’

principal financial risks stems from

losses associated with defaults on

mortgages that they hold or guarantee.

The other financial risk stems from

losses associated with changes in

interest rates. Because the effective

maturities of the Enterprises’ assets and

liabilities are not the same, interest rate

changes could cause the margin

between the average yield on assets and

the average yield on liabilities to narrow

or even become negative.

The Enterprises’ capital serves as a

cushion to absorb financial losses for a
Federal Register / Vol. 60, No. 26 / Wednesday, February 8, 1995 / Proposed Rules 7469

2For purposes of the ANPR, the term ‘‘capital’’

means ‘‘total capital’’ as defined under section

1303(18) of the Act (12 U.S.C. 4502(18)) to mean the

sum of the following:

(A) The core capital of the [E]nterprise;

(B) A general allowance for foreclosure losses,

which—

(i) shall include an allowance for portfolio

mortgage losses, an allowance for nonreimbursable

foreclosure costs on government claims, and an

allowance for liabilities reflected on the balance

sheet for the [E]nterprise for estimated foreclosure

losses on mortgage-backed securities; and

(ii) shall not include any reserves of the

[E]nterprise made or held against specific assets.

(C) Any other amounts from sources of funds

available to absorb losses incurred by the

[E]nterprise, that the [Director of OFHEO] by

regulation determines are appropriate to include in

determining total capital.

The term ‘‘core capital’’ is defined under section

1303(4) of the Act (12 U.S.C. 4502(4)) to mean the

sum of the following (as determined in accordance

with generally accepted accounting principles):

(A) The par or stated value of outstanding

common stock.

(B) The par or stated value of outstanding

perpetual, noncumulative preferred stock.

(C) Paid-in capital.

(D) Retained earnings.

The core capital of an [E]nterprise shall not

include any amounts that the [E]nterprise could be

required to pay, at the option of investors, to retire

capital instruments.

3Section 1361(a)(1) (12 U.S.C. 4611(a)(1)).

4Section 1361(a)(2) (12 U.S.C. 4611(a)(2)).

5Section 1361(a)(2)(C) (12 U.S.C. 4611(a)(2)(C)).

6Sections 1361(a)(2)(B) (12 U.S.C. 4611(a)(2)(B)).

7The Act states that OFHEO may consider the

impact of new business conducted during the stress

period after taking into consideration the results of

studies conducted by the Congressional Budget

Office and the Comptroller General on the

advisability and appropriate forms of new business

assumptions. The studies must be completed within

the first year after the issuance of the final riskbased capital regulation. OFHEO may incorporate

new business into the stress test four years after the

regulation is issued. Section 1361(a)(3)(C) and (D),

(12 U.S.C. 4611(a)(3)(C) and (D)).

8Sections 1361(b)(1) and (d) (12 U.S.C. 4611(b)(1)

and (d)). The Act uses the phrase ‘‘differences in

seasoning of mortgages’’ which is equivalent to

differences in LTVs. The term ‘‘seasoning’’ is

defined as the change over time in the ratio of the

unpaid principal balance of a mortgage to the value

of the property by which such mortgage loan is

secured. Section 1361(d)(1) (12 U.S.C. 4611(d)(1)).

9Sections 1361(b) and (d)(2) (12 U.S.C. 4611(b)

and (d)(2)).

10Section 1361(c)(2) (12 U.S.C. 4611(c)(2)).

period of time until the cause of the

losses can be remedied, thereby

reducing the risk of failure. The Act

requires OFHEO to establish, by

regulation, risk-based capital standards

for the Enterprises. The regulation will

describe a risk-based capital stress test

(stress test) that OFHEO will develop

and implement to determine for each

Enterprise the amount of capital 2

necessary to absorb losses throughout a

hypothetical ten-year period marked by

severely adverse circumstances (stress

period).

Use of a stress test will enable OFHEO

to tailor carefully the Enterprises’

capital standards to the specific risks of

the Enterprises’ businesses. It also will

provide a structure for incorporating

interrelationships among different types

of risk (prepayments, for example, relate

to both credit and interest rate risk).

Statutory Requirements

The Act specifies a risk-based capital

standard for each Enterprise. This

standard establishes the amount of

capital necessary to withstand

simultaneously adverse credit and

interest rate risk scenarios during the

stress period plus an additional amount

to cover management and operations

risk, as follows:

Credit Risk

The Act establishes a credit risk

scenario based on a regional recession

involving the highest rates of default

and loss severity experienced during a

period of at least two years in an area

containing at least five percent of the

total U.S. population. The stress test

will apply these default and loss rates,

with any appropriate adjustments, over

the ten-year stress period on a

nationwide basis to the Enterprises’

books of business.3

Interest Rate Risk

The Act presents two interest rate risk

scenarios, one with rates rising and the

other with rates falling. The Act further

describes the path of the ten-year

Constant Maturity Treasury (CMT) yield

for each scenario and directs OFHEO to

establish the yields of other financial

instruments during the stress period in

a reasonably consistent manner. The

stress test for each Enterprise

incorporates the scenario with the most

adverse impact.4

In the rising rate scenario, the ten-year

CMT yield increases during the first

year of the stress period and then

remains constant at the greater of (a) 600

basis points above the average yield

during the preceding nine months or (b)

160 percent of the average yield during

the preceding three years. The Act

further limits the increase in yield to a

maximum of 175 percent of the average

yield over the preceding nine months.5

In the falling rate scenario, the tenyear CMT yield decreases during the

first year of the stress period and then

remains constant at the lesser of (a) 600

basis points below the average yield

during the preceding nine months or (b)

60 percent of the average yield during

the preceding three years. The Act

further limits the decrease in yield to

not more than 50 percent of the average

yield in the preceding nine months.6

New Business and Other Activities and

Considerations

Initially the stress test assumes that

the Enterprises conduct no additional

new business once the stress period

begins, except for the fulfillment, in a

manner consistent with recent

experience and the economic

characteristics of the stress period, of

contractual commitments to purchase

mortgages and issue securities.7

The stress test must take into account

distinctions among mortgage product

types, different loan-to-value ratios

(LTVs), and any other appropriate

factors.8 OFHEO determines the

appropriate consideration and treatment

of all other factors, activities, or

characteristics of the stress period not

explicitly identified and/or treated in

the Act—such as mortgage prepayments,

hedging activities, operating expenses,

dividend policies, etc.—on the basis of

available information, in a manner

consistent with the stress period.9

Management and Operations Risk

Finally, to provide for management

and operations risk, after determining

the amount of capital an Enterprise

needs to survive the stress test, the Act

requires OFHEO to increase that amount

by 30 percent to set the required riskbased capital level for each Enterprise.10

Philosophy Guiding Stress Test

Development

The mission of OFHEO is to ensure

that the Enterprises are adequately

capitalized and operating in a safe and

sound manner, consistent with the

achievement of their public purposes.

The principal objective of risk-based

capital standards is protection of the

taxpayer from potential Enterprise

insolvency. However, effective capital

standards should also permit the

Enterprises to fulfill their public

purposes while pursuing prudent

business practices and strategies.

Although the stress test produces a

single capital requirement, it effectively

creates marginal capital requirements—

incremental requirements for each

additional dollar of business—for every

type of product the Enterprises

guarantee or hold in portfolio. Marginal

capital requirements for mortgages held

in portfolio will vary depending on the

risk, as reflected in the stress test, of an

Enterprise’s funding strategy. These

marginal capital requirements will have

significant bearing on how the

Enterprises choose to conduct their

businesses.

OFHEO will seek to design the stress

test so that the incentives it creates

closely reflect the relative risks inherent
7470 Federal Register / Vol. 60, No. 26 / Wednesday, February 8, 1995 / Proposed Rules

11For example, see C. Foster and R. Van Order,

‘‘An Option Based Model of Mortgage Default

Rick,’’ Housing Finance Review, 3(4):351–372,

1984; C. Foster and R. Van Order, ‘‘FHA

Terminations: A Prelude to Rational Mortgage

Pricing,’’ AREUEA Journal, 13(3):273–291, 1985;

and R.L. Cooperstein, F.S. Redburn, and H.G.

Meyers, ‘‘Modelling Mortgage Terminations in

Turbulent Times,’’ AREUEA Journal, 19(4):473–494.

For a review of the literature in this area, see R.G.

Quercia and M.A. Stegman, ‘‘Residential Mortgage

Default: A Review of the Literature,’’ Journal of

Housing Research, 3(2):341–379, 1992. 12Section 1361(a)(1) (12 U.S.C. 4611(a)(1)).

in the Enterprises’ different activities.

To this end, OFHEO will incorporate, to

the extent feasible, consistent

relationships between the economic

environment of the stress period and the

Enterprises’ businesses. This will

require modeling the Enterprises’ assets,

liabilities, and off-balance sheet

positions at a sufficient level of detail to

capture their various risk

characteristics. Taking all this into

consideration will require a balance

between the complexity and realism of

the stress test and its timeliness.

Solicitation of Public Comments

OFHEO requests public comment on

a number of subjects that must be

addressed in its risk-based capital

regulation. OFHEO will consider the

comments received in response to this

ANPR when developing a proposed

rule. Following consideration of

comments on the proposed rule, OFHEO

will issue a final regulation. When

addressing a specific question contained

in this ANPR, OFHEO asks that

commenters specifically note by number

which question is being addressed.

I. Credit Risk

The Enterprises face similar mortgage

credit risk in their portfolio and

securitization businesses. OFHEO

defines mortgage credit risk as the risk

of financial loss due to borrower default

and subsequent foreclosure and

liquidation of a mortgaged property.

Losses are realized when the unpaid

loan balance on a defaulted mortgage

exceeds the net proceeds of a

foreclosure sale, after deducting

carrying and selling costs, less any

recoveries from any private mortgage

insurer, recourse agreement, or other

credit enhancements.

Loans with high current LTVs, where

the borrowers have little to no equity in

their homes, are the most likely to

default.11 For any given set of mortgage

loans, the probability of default is

typically low in the first year after

origination, rises to a peak somewhere

between the third and seventh year, and

declines thereafter. If declining interest

rates induce prepayments on a group of

mortgage loans due to borrower

refinancing activity, defaults and losses

on those mortgage loans likely will be

reduced, because some of the prepaid

loans would ultimately have defaulted.

However, the remaining group of loans

is likely to be at greater risk of default,

because it includes all of the original

loans where the borrower would not

have qualified for refinancing, but only

some of the loans where the borrower

was eligible.

Economic downturns result in more

frequent and severe losses in all

categories of mortgage loans, especially

in a period of house price declines. The

stress test will incorporate changes in

the economic environment and simulate

the relationship of those changes to

mortgage defaults.

A. Defining a Stress Benchmark

The Act, in defining the risk-based

capital stress test, refers to two time

periods—a hypothetical ten-year ‘‘stress

period’’ during which the Enterprises’

capital should be sufficient to absorb

losses and maintain a positive capital

level while being subjected to adverse

credit and interest rate risk scenarios,

and the time period of ‘‘not less than

two years’’ for which the ‘‘highest rates

of default and severity of mortgage

losses’’ occurred in a region containing

at least five percent of the total

population of the United States.12 For

the purposes of this ANPR, OFHEO

characterizes the latter time period and

region as a ‘‘stress benchmark.’’ The

stress benchmark will provide the basis

for the development of the credit risk

stress scenario that will be applied

during the ten-year stress period.

The Act permits the identification of

one or more stress benchmarks. A single

benchmark is conceptually appealing

but presents a number of difficult

issues. A single benchmark may not

include sufficient data on all Enterprise

product types. Patterns of multifamily

and single family mortgage losses differ

(see ‘‘Mortgage Types’’ below) and a

stress benchmark for multifamily

mortgages representing the worst

regional experience for those mortgages

may not coincide with the benchmark

for single family mortgages based on

their worst experience. Finally, data

limitations may prevent OFHEO from

determining loss severities during the

period of highest default rates;

alternatively, highest loss severities may

not coincide with highest rates of

default by time period or region.

Although the Act does not refer to a

particular mortgage product in its

reference to ‘‘highest rates of default and

severity,’’ single family, 30-year, fixedrate mortgages have long comprised the

bulk of Enterprise mortgages. OFHEO

expects to define a stress benchmark for

these mortgages on the basis of a

weighted average (by unpaid loan

balance of various LTV groups) of

default rates.

Existing data on loss severities may be

inadequate to contribute to establishing

the timing or location of the worst

regional experience. Systems for the

storage and analysis of data on

foreclosed properties are a relatively

recent development. To overcome these

data deficiencies, OFHEO will consider

a number of approaches to determining

loss severity rates during the stress

benchmark. These approaches include

the use of loss severity estimates

obtained from different sources and for

different time periods and regions than

those used to estimate the benchmark

default rates.

OFHEO may use models (see ‘‘Models

of Default and Prepayment’’ and

‘‘Models of Loss Severity’’ below) to

establish aspects of the benchmark for

which data are insufficient or

unavailable. These might include, in

addition to loss severities for all

products, default rates for mortgage

products poorly represented or nonexistent in the stress benchmark.

Econometric models for default,

mortgage prepayment, and loss severity

would facilitate consideration of the

simultaneous impact of many factors on

default rates, such as changes in LTVs,

the impact of contemporaneous

prepayments, and the impact of factors

associated with mortgage product types.

Models would provide a link between

the performance of mortgages owned or

guaranteed by the Enterprises during the

stress period and performance during

the stress benchmark, with due

consideration of the economic

circumstances of the stress period, e.g.,

interest rates and house prices.

Data Issues

OFHEO has received access to

detailed information about the loss

experience on mortgages that the

Enterprises owned or guaranteed from

the mid-1970s through the present. The

type of information on mortgages that

OFHEO needs to develop the stress test

includes date of origination, original

LTV ratio, type of mortgage, location,

nature and degree of any credit

enhancements, date of last paid

installment, termination type, e.g.,

default or prepayment, and the amount

of any ultimate loss (including holding

and selling costs). However, there are

serious gaps in the data on loss severity

through the early 1980s resulting from

the lack of systems for the storage and
Federal Register / Vol. 60, No. 26 / Wednesday, February 8, 1995 / Proposed Rules 7471

13Age is often a proxy for additional unobserved

factors affecting the default probabilities of

individual mortgages. Immediately after origination,

default is unlikely for all borrowers. Default rates

first rise over time as new information about

properties and borrowers is revealed. Then as

relatively weaker borrowers default, the average rate

of default declines. See, for example, the discussion

in C. Pestre, P. Richardson, and C. Webster, ‘‘The

Lehman Brothers Mortgage Default Model and

Credit-Adjusted Spread Framework,’’ Mortgage

Market Analysis, Lehman Brothers, Fixed Income

Research, January 28, 1992. Other influential

default studies that have included mortgage age as

an explanatory factor include: T. Campbell and J.

Dietrich, ‘‘The Determinants of Default on

Conventional Residential Mortgages,’’ Journal of

Finance, 38(5):1569–1581, 1983; D. Cunningham

and C. Capone, ‘‘The Relative Termination

Experience of Adjustable to Fixed-Rate Mortgages,’’

The Journal of Finance, 45(5):1687–1703, 1990; and

J.M. Quigley and R. Van Order, ‘‘More on the

Efficiency of the Market for Single Family Homes:

Default,’’ Center for Real Estate and Urban

Economics, University of California, Berkeley, 1992.

14Section 1361(b)(1) (12 U.S.C. 4611(b)(1)).

15Section 1361(a)(2)(E) (12 U.S.C. 4611(a)(2)(E)).

16For an origination year benchmark, OFHEO

will likely have access to accurate information

about the original LTVs for all benchmark loans. On

the other hand, to develop an exposure year

benchmark, OFHEO will have to estimate LTVs

during the benchmark time period for all loans

Continued

analysis of data on foreclosed properties

and the manner in which loan balances

were reported by seller/servicers.

In general, however, with the increase

over time of the Enterprises’ share of the

overall mortgage market, the data grow

increasingly rich. If necessary, OFHEO

could supplement these data with data

from the Federal Housing

Administration or other sources such as

TRW Redi and Mortgage Information

Corporation.

If the stress benchmark is wholly or

primarily based on Enterprise data, the

loan-level data could be aggregated

across the two Enterprises in order to

determine the worst historical

experience. Preliminary analysis

suggests that the worst historical

experience may be different for the two

Enterprises. An alternative would be to

determine the worst historical

experience for each Enterprise

separately and then use a simple or

weighted average of default rates.

Question 1: What data and

methodology should OFHEO use in its

determination of the stress benchmark?

Benchmark Time Period and Region

OFHEO has considered at least two

approaches for defining the benchmark

time period. It could be defined as the

period in which the highest rates of

default occurred, that is, an ‘‘exposure

year’’ approach; or the period in which

the loans with the highest cumulative or

lifetime rates of default were originated,

which can be termed an ‘‘origination

year’’ approach. At the start of the stress

period, the Enterprises’ books of

business will include survivors from

many loan origination years. An

exposure year benchmark corresponds

more closely to the manner in which the

Enterprises’ mortgage portfolios will

experience the risk of credit losses as

they move through the ten-year stress

period. However, using exposure years

may complicate adjustments for

differences in LTVs and other factors

(see ‘‘Relating Stress Period Default

Rates to Benchmark Default Rates’’

below). Using origination years may

require some adjustment for differences

in mortgage age (see ‘‘Mortgage Age’’

below) since virtually all of the

Enterprise mortgages will have been

originated prior to the start of the stress

period.

Alternative approaches to defining the

stress benchmark (exposure year versus

origination year) suggest alternative

analyses of defaults. An exposure year

approach requires the determination of

default rates on loans of varying age at

risk of failure within a specified period.

The resulting time-period specific

default rates for loans outstanding at the

beginning of the period can be termed

‘‘conditional rates.’’ Because default

rates vary with the age of a mortgage

(see ‘‘Mortgage Age’’ below), OFHEO

might define an age schedule of

conditional default rates for loans

outstanding at the start of the stress

benchmark.13 For comparison across

time periods and regions, synthetic

cumulative default rates for the stress

benchmark could be derived under a

common set of prepayment

assumptions. In an origination year

approach, either cumulative or

conditional default rates could be used.

The Act requires that the benchmark

region comprise a contiguous area

containing at least five percent of the

total United States population. Part or

all of states such as Texas or California

satisfy this population requirement;

however, areas experiencing the highest

rates of default may cross over one of

these state’s boundaries into adjoining

states. As appropriate, OFHEO will use

a definition of benchmark region that

includes more than one state, part of

one state, or parts of several states.

Question 2: How should the

benchmark time period be defined?

Measurement of Default

Default can be defined in several

ways: Defaults can be deemed to occur

at the time a borrower ceases making

payments, when a loan payment is past

due by a contractually specified number

of days, on the date of foreclosure, or on

the date when losses are recognized.

Defaults can be measured on a gross

basis or net of any subsequent cures.

Question 3: What are the relative

merits of the alternative approaches for

the measurement of mortgage defaults?

B. Relating Stress Period Default Rates

to Benchmark Default Rates

Default rates during the stress period

may differ from the default rates

associated with the stress benchmark.

This difference may result from

differences between the characteristics

and composition of an Enterprise’s

mortgages at the start of the stress

period relative to those of the mortgages

identified with the stress benchmark.

Stress period default rates may also

differ from stress benchmark rates as a

result of differences in the stress period

environment, such as interest rates and

inflation. OFHEO must also specify the

timing of defaults and losses during the

stress period.

The Act requires that OFHEO, in

establishing the stress test, take into

account appropriate distinctions among

types of mortgage products, differences

in LTVs, and other factors that OFHEO’s

Director considers appropriate.14 Such

factors include prepayment activity,

mortgage age, and loan size. The Act

also requires an adjustment for the

effects of general inflation in the highest

interest rate environment in the stress

test.15

Loan-to-Value Ratios

The payment of principal and changes

in the value of the property securing a

mortgage affect LTVs over time.

Repayments of loan principal and rising

property values lower LTVs, while

falling property values raise LTVs.

Because LTV is a common measure of

borrower equity, and borrower equity is

a major factor determining defaults and

losses, the stress test must take into

account changes in LTVs. If

distributions of LTVs during the stress

period differ from those for the same

types of loans associated with the stress

benchmark, defaults and losses during

the stress period will likely differ from

those of the benchmark.

All loans owned or guaranteed by the

Enterprises at the start of the stress

period will have been originated prior to

that time. Although relatively good

estimates of property value are available

at the time of loan origination, OFHEO

will need to use house price indexes to

obtain estimates of the LTVs for

mortgages at the start of, and possibly

throughout, the stress period.16 OFHEO
7472 Federal Register / Vol. 60, No. 26 / Wednesday, February 8, 1995 / Proposed Rules

originated earlier. OFHEO would use house price

indexes for this purpose.

17See Foster and Van Order, supra, (1984, 1985).

18Sections 1361(b)(1) and (d)(2) (12 U.S.C.

4611(b)(1) and (d)(2)).

19Section 1361(a)(1) (12 U.S.C. 4611(a)(1)).

20 Government Accounting Office, ‘‘Federal Home

Loan Mortgage Corporation: Abuses in Multifamily

Program Increase Exposure to Financial Losses’’

(Oct. 1991); J.M. Abraham, ‘‘On the Use of a Cash

Flow Time-Series to Measure Property

Performance,’’ forthcoming in Journal of Real Estate

Research; and J.M. Abraham, ‘‘Credit Risk in

Commercial Real Estate Lending, ‘‘Federal Home

Loan Mortgage Corporation, 1994 presented at the

1994 meetings of the American Real Estate and

Urban Economics Association (available from

OFHEO).

21Sections 1331–1336 (12 U.S.C. 4561–4566).

22Section 1361(a)(2)(E) (12 U.S.C. 4611(a)(2)(E)).

intends to use a repeat sales index based

on sales (or appraisals undertaken by

borrowers in conjunction with

refinancing the mortgages) of the

Enterprises’ owned and guaranteed

portfolios (see ‘‘House Price Indexes’’

below).

Models of mortgage default and

prepayment (see ‘‘Models of Default and

Prepayment’’ below) emphasize the

importance of LTV because of its direct

relationship to homeowner’s equity,

defined as the difference between the

value of a property and the outstanding

principal balance of the related

mortgage. These models differ in their

treatment of house price changes and

with regard to how changes in equity

affect default and prepayment. For

example, one approach assumes that

defaults occur only among loans with

negative equity.17 House price indexes

only provide estimates of the average

change in property values between two

dates. Because changes in individual

property values are not continuously

observed, simulation models have been

used to characterize the distribution of

changes in house prices relative to the

market average. Estimates of the

percentage of loans with negative equity

and estimates of default rates can be

derived from these distributions.

This approach assumes that

homeowner’s equity includes not just

the difference between property value

and outstanding loan amount, but also

the current value of the mortgage to the

borrower. A below-market rate loan has

positive value. The precise value of the

mortgage depends on the loan interest

rate relative to the current market rate

and the borrower’s expectations about

future interest rates and mobility. A

borrower whose loan has a fixed

contract rate below current market

yields has more to lose by defaulting

than a borrower with a note rate above

the current market rate.

Question 4: What is the appropriate

way in which to adjust the LTVs of

mortgages in the stress test?

Question 5: If estimates of the

distribution of house price changes are

used to adjust the LTVs of mortgages,

what is an appropriate method, e.g.,

stochastic process?

Question 6: In what manner, if at all,

should OFHEO incorporate mortgage

value as a factor affecting defaults?

Mortgage Types

Single Family

The Act requires that the stress test

consider differences in mortgage types

(single family or multifamily, fixed or

adjustable rate, first or second lien,

owner-occupied or investor owned,

positive or negative amortization,

alternate term to maturity, etc.).18 Risk

characteristics of different types of

mortgages vary considerably. Because of

the fundamental differences between

single family and multifamily mortgage

risk, we discuss the latter in a separate

section below.

Given that OFHEO plans to establish

the stress benchmark based on single

family, 30-year, fixed-rate mortgages,

the Act calls for OFHEO to identify the

worst rates of default and losses for any

time period or region.19 The Enterprises

may not have held certain types of

single family mortgages in the stress

benchmark OFHEO identifies. Other

types of single family mortgages held

during the stress benchmark may have

experienced their worst defaults and

losses at other times or in other regions.

Alternative approaches could include

use of multivariate models to estimate

separate equations for different

mortgage products or different mortgage

features, default rates representing some

multiple of the standard single family

mortgage, or some combination of these

approaches (see ‘‘Models of Default and

Prepayment’’ below).

Question 7: How should OFHEO

relate other types of mortgages to a

single stress benchmark developed

based on single family, 30-year, fixedrate mortgages?

Multifamily

While single family properties are

both a source of shelter and, for most

families, their most valuable financial

asset, multifamily properties are

primarily income-producing businesses

for their owners. Multifamily loans are

less homogeneous and subject to a more

diverse set of risks than single family

loans. The multifamily market has more

pronounced business cycles and is

heavily affected by tax and regulatory

policy. Patterns of losses over time for

multifamily loans have not tracked

those of the single family market. The

Enterprises operate several different

types of multifamily programs, some of

which rely heavily on lender recourse or

other forms of credit enhancement with

differing risk characteristics.

Data needs in analyzing multifamily

loans are greater than for single family

loans and yet the quality of such data is

poorer. Data are incomplete and cover a

smaller portion of the multifamily

market than the single family market.

There is also a dearth of research on

critical multifamily credit risk issues.

For the owner of a multifamily

property, net operating income (NOI)

plays a more important role than equity

in the decision to default. A property’s

debt service coverage, rather than LTV

ratio, may be the most important

indicator of multifamily credit risk, yet

available data can only provide a short

time-series for income. Multifamily

value indexes are problematic because

there are fewer transactions than in the

single family market and property

appraisals are less reliable. Appraisals

are less reliable due to the varying

methodologies used to calculate

multifamily property income and the

application of so-called ‘‘capitalization

rates’’ to NOI.20

Prepayments play a far less significant

role in the analysis of multifamily credit

risk than single family credit risk

because ‘‘lockouts’’ and yield

maintenance agreements effectively

prevent most multifamily borrowers

from refinancing to take advantage of

declining interest rates. The Enterprises’

activity in the multifamily market is

expected to increase significantly in

future years in order to meet the

affordable housing goals established

under the Act.21 Thus, the treatment of

multifamily risks will be increasingly

important.

Question 8: How should existing and

emerging multifamily data sources be

identified?

Question 9: What are alternative

empirical and theoretical approaches to

the estimation of multifamily credit

risk?

Question 10: How should the

projection of defaults and losses on the

Enterprises’ multifamily portfolio be

related to a single family stress

benchmark?

General Price Inflation

The Act requires that OFHEO adjust

credit losses in the stress test when large

increases in interest rates imply higher

rates of general price inflation.22 If the

ten-year CMT yield is assumed to

increase by more than 50 percent over

the average yield during the preceding
Federal Register / Vol. 60, No. 26 / Wednesday, February 8, 1995 / Proposed Rules 7473

23For example, see the papers cited in footnote

11 above.

24 Due to the unique difficulties of modeling

multifamily default and prepayment, multifamily

and single-family loans would probably need to be

modeled separately. The modeling of loss severity

is discussed in the next section.

25Multinomial logit models for default have been

estimated by Campbell and Dietrich (1983) supra;

P. Zorn and M. Lea, ‘‘Mortgage Borrower

Repayment Behavior: A Microeconomic Analysis

with Canadian Adjustable Rate Mortgage Data,

AREUEA Journal, 17(1):188–136, 1989; and

Cunningham and Capone (1990) supra. More

recently, proportional hazards models have been

used to analyze default and prepayment. See, for

example, J. Quigley, ‘‘Interest Rate Variations,

Mortgage Prepayments and Household Mobility,

Review of Economics and Statistics, 119(4):636–

643, 1987; and J.M. Quigley and R. Van Order,

‘‘More on the Efficiency of the Market for Single

Family Homes: Default,’’ Center for Real Estate and

Urban Economics, University of California,

Berkeley, 1992.

nine months, inflation is presumed to be

‘‘correspondingly higher.’’ If, for

example, the ten-year CMT yield were

to have averaged eight percent during

the past nine months, a 50 percent

increase would raise it to 12 percent.

The Act, however, would permit an

increase to 14 percent.

OFHEO would first determine what

annual percentage difference in general

inflation rates best corresponds to the

difference between a 12 percent and a

14 percent ten-year CMT yield over a

nine-year period. The difference in

inflation rates could be assumed to be

equal to the difference in interest rates

or it could be based on an estimated

historical relationship.

OFHEO would then translate that

higher inflation rate into individual

house price changes. Again, the

differences in house price changes

could be assumed to be equal to the

difference in general price inflation

rates or could be based on an estimated

relationship.

As the last step, OFHEO would

translate the difference in house price

changes into differences in defaults.

This could be done in the context of a

multivariate default and prepayment

model used for making many

adjustments simultaneously (see

‘‘Models of Default and Prepayment’’

below), or it could be the subject of a

separate analysis.

Question 11: Should OFHEO assume

a ‘‘one-to-one’’ relationship between

long-term differences in interest rates,

general price inflation rates, and house

price inflation rates or should it

estimate more complex, but potentially

more realistic, relationships between

these phenomena?

Question 12: What is the best method

of modeling the effects of higher house

prices on defaults?

Mortgage Prepayments—Credit Risk

Prepayments are a significant factor in

interest rate risk, but they also affect

credit losses. Interest rate changes have

a significant influence on mortgage

prepayments. Prepayment rates are

sensitive to the differences between

current market yields and the levels of

mortgage rates among outstanding

mortgages. A homeowner today will

refinance (and prepay) when current

mortgage rates fall as little as 50 basis

points below the rate on his or her

mortgage.

Prepayment rates also depend on the

time paths of interest rates.

Homeowners who fail to refinance once

mortgage rates become advantageous are

relatively unlikely to do so in the future

(many may not qualify for refinancing).

Thus, prepayment rates for mortgages

with a given coupon rate rise as interest

rates fall below a particular threshold,

but they eventually will slow, even if

interest rates remain at the new lower

levels or continue to decline. This

phenomenon is commonly known as

‘‘burn-out.’’

The expected pattern of prepayments

in the stress period might be quite

different from the pattern experienced

during the benchmark period. The

drastic yield curve shifts that will be

experienced during the initial year of

the stress period will almost certainly

not be found during the benchmark

period that OFHEO must identify. The

greater number of mortgages that

prepay, the fewer are the candidates for

subsequent default. Conversely, the

fewer mortgages that prepay, the greater

the number remaining that might

default. At the same time, the default

risk of mortgages remaining after a

refinancing wave may be higher than

previously. Many homeowners who did

not take advantage of attractive

refinancing opportunities may have

been unable to do so because of higher

risk profiles. Given the widely divergent

interest rate movements that the

Enterprises may experience during the

stress period, loss adjustments for

differing prepayment behavior could be

considerable.

If OFHEO expresses mortgage default

rates as conditional rates, defaults

during any given time interval of the

stress period will depend on the

proportion of mortgages outstanding at

the beginning of that time interval. Such

an approach would, in effect, make a

substantial adjustment for prepayments.

A more complicated adjustment would

take into account the generally higher

quality of loans eligible for refinancing.

In a stress scenario involving falling

interest rates, for example, the stress test

might take into account the generally

higher quality of loans that qualify for

refinancing and the potentially lower

quality of surviving loans (see ‘‘Models

of Default and Prepayment’’ below).

Alternatively, if the stress test involves

no interaction of the total amount of

defaults and prepayments, OFHEO still

might adjust the timing of defaults

during the stress period to be consistent

with prepayments expected in a

particular interest rate scenario.

Mortgage prepayments are discussed

further under ‘‘Interest Rate Risk’’

below.

Question 13: Should anticipated

prepayments affect the volume or timing

of defaults in the stress period?

Mortgage Age

Holding homeowner’s equity

constant, a number of factors make the

likelihood of borrower default vary over

the life of a loan. On one hand, changes

in a borrower’s circumstances

subsequent to the loan’s origination,

such as unemployment, marriage,

divorce, childbearing, mortality, and

residential mobility, affect the

likelihood of default and prepayment,

and the cumulative frequency of such

events increases as a loan ages. On the

other hand, a record of consistent

payments by a borrower over time

increases the probability of continued

loan performance.

Models that have included variables

for both homeowner’s equity and

mortgage age have found the

contribution of age to be statistically

significant.23 This may be particularly

important if an origination year

approach is used in the benchmark.

Using an origination year approach,

loans in the stress benchmark would all

be newly originated loans, while those

at the beginning of the stress period

would be a mixture of old and new

loans.

Question 14: Is it appropriate for

OFHEO to factor mortgage age into the

stress test, and, if so, what is the best

method of doing so?

C. Models of Default and Prepayment

There are a number of approaches to

relating the factors discussed above,

such as LTV, mortgage type, mortgage

age, and prepayments, to the

performance of the Enterprises during

the stress period. A comprehensive way

to incorporate all of these factors into

the stress test would be to estimate joint

multivariate models of default and

prepayment.24 A joint model of default

and prepayment would ensure the

consistency of these key variables and

reflect an appropriate time pattern of

defaults as well. Researchers have

estimated a number of such models.25
7474 Federal Register / Vol. 60, No. 26 / Wednesday, February 8, 1995 / Proposed Rules

26See, for example, T. Clauretie and T.N. Herzog,

‘‘How State Laws Affect Foreclosure Costs,’’

Secondary Mortgage Markets, 6(Spring):25–28,

1989; T. Clauretie and T.N. Herzog, ‘‘The Effect of

State Foreclosure Laws on Loan Losses: Evidence

from the Mortgage Insurance Industry,’’ Journal of

Money, Credit, and Banking, 22(2):221–233, 1990;

E. Bruskin and M. Buono, ‘‘A New Understanding

of Loss Severity: Time is (of) the Essence,’’ in

Mortgage Securities Research, Goldman-Sachs,

September 1994; and V. Lekkas, J. Quigley, and R.

Van Order, ‘‘Loan Loss Severity and Optimal

Mortgage Default,’’ AREUEA Journal, 21(4):353–

371, 1993.

A joint approach to default and

prepayment would generate default

rates reasonably related to the stress

benchmark, while simultaneously

generating prepayment rates that are

consistent with the interest rate

characteristics of the ten-year stress

period. To estimate a multivariate

default/prepayment model, OFHEO

could draw on all relevant historical

data, not just data from the stress

benchmark. The model might include

explanatory variables such as LTVs at

origination, current LTVs (determined

through the application of an

appropriate house price index),

differences between actual mortgage

coupons and current market rates,

interest rate paths, mortgage age,

dummy variables for time period and

location of mortgaged property, and

additional characteristics specific to

different mortgage products. The

estimation procedure could allow for

changing coefficients over time to reflect

structural changes in prepayment and

default behavior. During the stress

period, explanatory or dummy

variables, reflecting the special

circumstances of the stress benchmark,

would be set at their benchmark levels.

While multivariate models allow for

the most realistic estimates of defaults

and prepayments, OFHEO recognizes

the difficulties of such an approach.

Insufficient data may complicate model

selection and the estimation of some

individual parameters. One of the most

simple approaches would be to measure

cumulative defaults in the stress

benchmark for the most common 30-

year, fixed-rate, 80 percent LTV

mortgages and then spread those

defaults evenly or according to some

predetermined pattern over the ten-year

stress period, with no consideration of

prepayments. Losses on other mortgage

types and LTVs could be set at simple

multiples of the ‘‘standard’’ loss rate

based on average historical experience.

All other possible variables might be

ignored.

Many approaches of intermediate

complexity exist. For example, OFHEO

could determine the stress benchmark

default rates for standard 30-year, fixedrate, single family mortgages for several

LTV categories and a few other types of

mortgages. Relative defaults on

additional mortgage types would be

determined from more recent data using

multivariate models, which would also

provide adjustment factors for some

mortgage features and other relevant

variables. Prepayments could be

modeled separately, affecting projected

defaults by changing the volume of

surviving loans (See ‘‘Mortgage

Prepayments—Interest Rate Risk’’

below). The time patterns of defaults

could also be modeled separately as a

function of mortgage age.

Question 15: What are the relative

merits of using a joint model of default

and prepayment in the stress test?

Question 16: What is an appropriate

statistical method for estimating a joint

model of default and prepayment?

Question 17: Should defaults be

expressed in terms of conditional failure

rates (hazards), cumulative default rates,

or in some other manner?

Question 18: What explanatory

variables should be included in a

statistical model for default and

prepayment?

Question 19: What is an appropriate

level of statistical aggregation for the

estimation of a joint model of default

and prepayment?

Question 20: How should the impact

of house price trends, interest rates, and

other economic factors be incorporated

into a model of default and prepayment?

D. Models of Loss Severity

Due to the varying quality of data on

losses on defaulting loans, OFHEO may

be unable to establish actual loss

severities for the stress benchmark. Even

if loss severities are incorporated in the

stress benchmark, OFHEO may make

adjustments to reflect changes in factors

that affect loss severities. Consequently,

OFHEO will conduct a separate analysis

of loss severity based on all available

data. This section examines some of the

issues involved in modeling loss

severity, including approaches for

linking loss severity rates to the stress

benchmark.

Loss severity refers to the actual

dollars lost on a defaulted loan and

allows credit risk to be quantified in

dollar terms. Severity is the extent to

which the costs associated with default,

foreclosure, and disposition exceed the

revenues associated with these

processes. The major costs are the loss

of loan principal, transaction costs at

both foreclosure and disposition, and

carrying costs throughout the process.

The major revenues are foreclosure sale

price and mortgage insurance payments.

Loss severity, like default, depends on

numerous factors. Some factors—

original LTV ratio, LTV ratio at time of

default, original loan size, occupancy

status, type of structure, and presence or

absence of mortgage insurance—are the

factors that also influence the likelihood

of default. Other factors—methods of

disposition, state foreclosure laws, and

home price movements after default—

influence severity without affecting the

likelihood of default.26

OFHEO is considering using a

multivariate statistical model to

estimate the separate effects of these

factors on severity. OFHEO may develop

a separate model for each of the cost and

revenue components of loss severity

since each component is affected by

different factors. In the event that data

on the individual revenue and cost

components of loss severity are

unavailable, an alternative approach

would be to model overall loss severity

directly.

Another less complex option is to

estimate the individual components

without multivariate statistical analysis.

OFHEO could set fixed parameters for

the components of severity—foreclosure

costs might be x percent of unpaid

principal balance (UPB), carrying costs

equal to y percent of UPB and sales

prices being z percent of UPB—while

allowing severity to vary based on, for

example, the presence or absence of

private mortgage insurance or state

foreclosure laws. The simplest possible

option would be to assume that all

defaulted loans face the same level of

severity as a percentage of UPB.

There are a number of ways in which

rates of loss severity may be related to

the stress benchmark rates of default

and the corresponding rates of default

during the stress period. Given the

impact of state foreclosure laws on loss

severity, default rates and loss severity

will be linked through the geographic

location of the mortgages. For example,

loss severities are likely to be lower in

states where foreclosure laws are

relatively more favorable to the lender.

The assumptions about changes in

house prices in the stress benchmark

and during the stress period will affect

the determination of foreclosure sales

prices and loss severity. Defaults are

more likely to have occurred when

borrowers’ properties have appreciated

much less than the average for their

region. This implies that house price

indexes used to model loss severity

would best be based on properties that

have experienced lower than average

appreciation.
Federal Register / Vol. 60, No. 26 / Wednesday, February 8, 1995 / Proposed Rules 7475

27Section 1361(d)(1) (12 U.S.C. 4611(d)(1)).

28See W. Stephens, Y. Li, V. Lekkas, J. Abraham,

C. Calhoun, and T. Kimner, ‘‘Agency Repeat

Transactions,’’ revised August 1994, forthcoming in

Journal of Housing Research (available from

OFHEO).

29Methodological issues related to the estimation

of repeat transaction house price indexes are

discussed in the following papers: M.J. Bailey, R.F.

Muth, and H.O. Nourse, ‘‘A Regression Method of

Real Estate Price Index Construction,’’ Journal of

the American Statistical Association, 58:933–942,

December 1963; K.E. Case and R.J. Shiller, ‘‘Prices

of Single-Family Homes since 1970: New Indexes

for Four Cities,’’ New England Economic Review,

45–56, September/October 1987; K.E. Case and R.J.

Shiller, ‘‘The Efficiency of the Market for Single

Family Homes,’’ American Economic Review,

79:125–137, 1989; J.M. Abraham, J.M. and W.S.

Schauman, ‘‘New Evidence on Home Prices from

Freddie Mac Repeat Sales,’’ Journal of the American

Real Estate and Urban Economics Association,

19:333–352, 1991; C.A. Calhoun, ‘‘Estimating

Changes in Housing Values from Repeat

Transactions,’’ Federal National Association

International meetings (available from OFHEO); and

C.A. Calhoun, P. Chinloy, and I.F. Megbolugbe,

‘‘Temporal Aggregation and House Price Index

Construction,’’ Federal National Mortgage

Association, forthcoming in Journal of Housing

Research (available from OFHEO); and B. Case, H.O.

Pollakowski, and S.M. Wachter, ‘‘On Choosing

Among House Price Index Methodologies,’’ Journal

of the American Real Estate and Urban Economics

Association, 19(3):286–307, 1991. 30See Stephens, et al., supra.

Question 21: What are the explanatory

factors OFHEO should consider in

modeling loss severity?

Question 22: Should OFHEO model

the individual cost and revenue

components of severity or should

OFHEO model only overall severity?

Question 23: What is an appropriate

house price index for real estate owned

(REO) properties? In estimating

foreclosure sales prices, should OFHEO

use a house price index based on all

properties or a house price index based

only on REO properties?

E. House Price Indexes

The Act requires that OFHEO use

house price indexes to determine

changes in the values of properties

securing mortgages owned or

guaranteed by the Enterprises and the

corresponding changes in LTVs.

Changes in property values are—

determined on an annual basis by region, in

accordance with the Constant Quality Home

Price Index published by the Secretary of

Commerce (or any index of similar quality,

authority, and public availability that is

regularly used by the Federal Government).27

Since the second quarter of 1994, the

Enterprises have published the quarterly

Conforming Mortgage House Price Index

(CMHPI) for the nine Census divisions.

This represents a significant

improvement over the annual four

Census region Commerce Constant

Quality Index (CCQI). The CMHPI is

based on a weighted repeat sales (WRS)

approach in which multiple

transactions, i.e., mortgage originations,

for individual properties are matched by

street address to obtain changes in sales

prices or appraisal values. Observed

property values and transactions dates

are then combined in a multivariate

statistical model to estimate an index of

housing values.28

OFHEO believes that a WRS index

based on Enterprise data offers a

number of advantages for estimating the

changing LTVs of the Enterprises’

mortgage assets. Perhaps foremost

among these is the direct

correspondence between index data and

the housing segment serviced by the

Enterprises. This factor, along with

others, should make the index more

accurate for establishing the current

market values of properties securing

mortgages held or guaranteed by the

Enterprises. In addition, a WRS index

based on Enterprise data will allow

OFHEO to estimate changes in housing

values at lower levels of geographic and

temporal aggregation, and with greater

statistical precision, than the CCQI

allows. In order to meet the

requirements of the Act regarding the

use of an alternative house price index,

OFHEO will produce and publish a

similar house price index or indexes

using data on the historical mortgage

transactions of the Enterprises.

Issues that have a bearing on the

application of house price indexes to

the risk-based capital test include the

appropriate level of geographic

aggregation, sample selection and

appraisal bias, and the effect of index

revisions as new data becomes

available.29

Geographical Aggregation

Aggregation across housing markets

with imperfectly correlated house price

changes will result in biased estimates

of the average levels of appreciation in

individual markets. This bias can be

characterized in terms of the smoothing

of market-wide indexes, with a

corresponding increase in the apparent

volatility of individual house prices

around the market index. Excessive

disaggregation, however, may reduce

the frequency at which indexes can be

meaningfully computed and subject

them to large revisions.

Question 24: What principles should

OFHEO use in selecting the optimal

level of geographic aggregation for the

stress test?

Bias

As discussed below, potential sources

of statistical bias include sample

selection bias and appraisal bias.

Sample Selection Bias

Even within the total database of

Enterprise mortgages, non-random

sampling of individual properties with

repeat transactions could result in an

index that is biased for the larger

population of Enterprise properties. For

example, the conforming loan limit and

year-to-year changes in the limit could

result in sample selection bias in the

estimated parameters of a repeat

transactions index. A closely related

form of sample selection bias can occur

when the waiting time between repeat

transactions is correlated with the

change in house prices. For example, if

more rapidly appreciating properties

turn over within shorter time intervals,

they will appear in the repeat sample

more quickly. In this case, appreciation

rates for repeat transactions near the end

of the sample period will not be

representative. Thus, sample selection

bias would be greater near the end of the

index.

Appraisal Bias

Approximately 85 percent of the

repeat transactions used by the

Enterprises to estimate WRS house price

indexes involve a refinance

transaction.30 Appraisals provide useful

information on house values in the

absence of sales transactions. However,

the use of appraisals in real estate

valuation is thought to impart bias by

smoothing the fluctuations in housing

values. Appraisals are derived through

comparisons with properties that have

either been sold or listed for sale within

the past several months and may fail to

indicate more recent changes in housing

values.

Question 25: Should house price

indexes estimated using Enterprise data

include adjustments for identifiable

sources of statistical bias?

Question 26: What additional sources

of statistical bias exist and what are

possible corrective actions that may be

taken to address them?

Question 27: What methods of

accounting and correcting for sample

selection bias should be used?

Question 28: Should a statistical

adjustment to the WRS house price

index be made to address the impact of

appraisal bias?

Revision Volatility

As data on new transactions are

obtained each quarter, new repeat

transactions can be combined with

transactions that occurred in the past.

Thus, the quarterly index estimation

process involves the revision of the

entire index in light of new information.
7476 Federal Register / Vol. 60, No. 26 / Wednesday, February 8, 1995 / Proposed Rules

31Federal National Mortgage Association Charter

Act, section 302(b)(2) and (5)(C) (12 U.S.C.

1717(b)(2) and (5)(C)), and Federal Home Loan

Mortgage Corporation Act, section 305(a)(2) and

(4)(C) (12 U.S.C. 1454(a)(2) and (4)(C)).

32 ‘‘S&P’s Structured Finance Criteria,’’ Standard

& Poor’s (1988).

33The market value of Fannie Mae’s liabilities

(primarily market-rate, short-term securities)

exceeded the market value of its assets (primarily

below market-rate residential mortgages).

Depending on the level of geographic

aggregation, this can result in

substantial changes in historical values

of the index and the implied changes in

the LTVs of Enterprise mortgages.

Question 29: Should changes in WRS

indexes resulting from revision

volatility be reflected in indexes used in

a stress test? If so, what should be the

frequency of such revisions?

F. Third Party Credit Issues

The Enterprises have credit exposure

to institutions that provide mortgage

credit enhancements or that serve as

counterparties to derivative

transactions. This exposure arises

because the adverse economic

environment of the ten-year stress

period may cause some fraction of these

institutions to fail and be unable to meet

their financial obligations to the

Enterprises.

Credit Enhancements

The Enterprises reduce their exposure

to mortgage credit losses through a

variety of credit enhancements that

transfer some or all of the risk to other

parties. These credit enhancements

include lender recourse, mortgage

insurance, and pool insurance.

The use of mortgage insurance

illustrates how credit enhancements

work to mitigate credit losses and

highlights some of the issues OFHEO

must address. Generally, the Enterprises

may not purchase a conventional

mortgage whose LTV ratio exceeds 80

percent unless the seller retains a

participation interest or enters into a

repurchase agreement, or unless the

mortgage is insured by a qualified

insurer.31 If insured mortgages

experience actual losses, the insurance

fully or partially compensates the

Enterprises for those losses.

Applying an approach used by credit

rating agencies for private mortgage

insurers, some insurers may be assumed

to go out of business during the stress

period.32 To reflect this possibility,

OFHEO’s stress test might assume the

failure of some fraction of the private

mortgage insurers who would then be

unable to entirely fulfill their

contractual obligations to the

Enterprises.

Question 30: How should OFHEO

calculate loss mitigation due to credit

enhancements?

Question 31: What should OFHEO

assume about the scope of coverage

provided by credit enhancements?

Question 32: What assumptions

should OFHEO make regarding the

failure of credit enhancements over the

stress period?

Derivatives Counterparties

The Enterprises use non-mortgage

derivatives—interest rate and foreign

exchange rate contracts—to hedge

interest rate and foreign exchange rate

risk. Should a counterparty default on

its obligation under a derivative

contract, an Enterprise may have to pay

a new counterparty to take on the

remaining obligation.

Derivatives counterparties present

some of the same issues as credit

enhancements. Generally, during an

economic downturn, as one

counterparty’s credit deteriorates, the

other party to the transaction may

increase collateral requirements until

eventually the value of pledged

collateral more than covers risk

exposure. Therefore, with prudent

counterparty risk management, losses

are most likely to occur due to

unexpected counterparty bankruptcies.

Such losses may be more directly

related to potential financial market

disturbances than to general economic

conditions.

Question 33: How, if at all, should

OFHEO incorporate the effect of

counterparty defaults in the risk-based

capital test?

G. Non-Mortgage Investments

The Enterprises maintain nonmortgage investment portfolios that

include Treasury securities, federal

funds, time deposits, obligations of

states and municipalities, auction rate

preferred stock, medium-term notes,

asset-backed securities, repurchase

agreements, and other instruments. At

the end of the third quarter in 1994,

these investments totaled $11.5 billion

at Freddie Mac and $35.1 billion at

Fannie Mae. On average in recent

quarters, these investment portfolios

have ranged from two to five percent of

assets plus MBS.

Many of these investments or their

issuers are rated by the credit rating

agencies. Even though these are very

short-term and liquid investments, some

of the issuers or the investments may be

assumed to default during the stress

period. To reflect this possibility,

OFHEO’s stress test might assume the

failure of some fraction of the

investments or issuers, based on their

credit rating.

Question 34: How should OFHEO

simulate the default behavior of

investments or issuers of short-term,

liquid investments?

Question 35: What assumptions

should OFHEO make about the

performance of rated investments or

issuers over the stress period?

Question 36: What assumptions

should OFHEO make about gains and

losses on the sale of collateral for

repurchase agreements?

II. Interest Rate Risk

Interest rate risk, associated primarily

with the maintenance of a retained

portfolio, caused the most serious losses

ever experienced by the Enterprises. For

a time during the early 1980’s, Fannie

Mae, which was then almost exclusively

a portfolio institution, was insolvent on

a mark-to-market basis.33 (Freddie Mac

focused much more completely on

mortgage pass-through securities during

that time period.) As did much of the

thrift industry at the time, Fannie Mae

funded long-term, low-yield, fixed-rate,

single family mortgages with short-term

liabilities; rising interest rates drove up

funding costs, causing Fannie Mae to

incur significant losses.

Since then, Fannie Mae and Freddie

Mac (the latter has built a substantial

retained portfolio over the past decade)

have developed funding strategies that

reduce their exposure to interest rate

risk. To protect against rising rates,

liabilities have been lengthened to

match more closely the maturity of

mortgage assets. When falling interest

rates result in accelerated mortgage

prepayments, callable debt structures

now allow the Enterprises to retire some

debt early or issue new debt to maintain

more closely their desired net interest

margin. Adjusting hedging strategies for

adjustable-rate mortgage investments

presents a more difficult problem.

The Enterprises have recently been

building mortgage derivative portfolios

that have an interest rate risk profile

more complex than those of whole

mortgages.

Interest rate risk also affects income

from the Enterprises’ securitization

businesses. Float income—the return on

invested mortgage principal and interest

payments prior to the corresponding

payment to investors—varies with the

level of interest rates at which the

Enterprises reinvest such funds. Interest

rates affect prepayment rates, and

changing prepayments affect float

income at each Enterprise.

A number of issues related to the

interest rate risk of the Enterprises are

discussed below.
Federal Register / Vol. 60, No. 26 / Wednesday, February 8, 1995 / Proposed Rules 7477

34Section 1361(a)(2)(D) (12 U.S.C. 4611(a)(2)(D)).

35Section 1361(a)(2) (B) and (C) (12 U.S.C.

4611(a)(2) (B) and (C)).

A. Yield Curve Construction

The Act provides specific instructions

concerning the ten-year CMT yield over

the ten years of the stress test, but other

points on the Treasury yield curve are

important as well. The Treasury yield

curve determines, directly or indirectly,

the yields on adjustable-rate mortgages,

the returns on non-mortgage

investments and the costs of borrowing.

The Act calls for Treasury yields of

different maturities to be determined in

a way that is ‘‘reasonably related to

historical experience and are judged

reasonable by the Director.’’ 34

Question 37: How should OFHEO

determine the remainder of the Treasury

curve and apply the curve through the

ten-year stress period?

Question 38: How should the other

points on the yield curve change during

the first year when the ten-year CMT

yield is rising or falling?

Question 39: How, if at all, should

those yields vary after the one-year

period when the ten-year CMT yield has

reached its maximum or minimum

level?

B. Mortgage Prepayments—Interest Rate

Risk

The financing of a mortgage portfolio

presents one of the greatest challenges

of asset/liability management. A

portfolio manager can eliminate interest

rate risk only if he or she issues

liabilities with maturities, rate

adjustments, and embedded options

matching those of the mortgage assets.

In a declining rate environment, should

mortgages pay down more quickly than

liabilities, new low-yield mortgages

added to the portfolio will likely reduce

the net interest margin; in a rising rate

environment, if liabilities run off more

quickly than the mortgage assets, the net

interest margin will likely fall due to

higher funding costs.

Since the Enterprises absorb the credit

risk of MBS, MBS dealers and investors

principally concern themselves with

interest rate risk. The tremendous

volume of MBS outstanding, and the

great sensitivity of MBS value to interest

rate movements and resulting

prepayment rates, have resulted in a

significant research emphasis on

prepayments by Wall Street analysts.

Although most Wall Street MBS pricing

models focus on prepayments, these

models are estimated based on mortgage

termination data that do not distinguish

prepayments from defaults. For the

purpose of modeling interest rate risk,

the distinction is irrelevant.

The section above titled ‘‘Models of

Default and Prepayment’’ suggests an

approach to the stress test that combines

the simulation of defaults and

prepayments in a joint multivariate

model, making a termination model

unnecessary. Use of a mortgage

termination model for interest rate risk

analysis runs the risk of generating

implausible patterns of prepayments

because, depending on the approach to

default projections, defaults in some

years of the stress period might

approach or exceed total projected

mortgage terminations.

Question 40: What are the relative

merits of the alternative approaches,

e.g., a joint multivariate default/

prepayment model versus a mortgage

termination model, to modeling

mortgage prepayments in the stress test?

C. Liabilities

The Enterprises’ liabilities may take

the form of bonds and notes with simple

structures; so-called ‘‘structured notes,’’

possibly combined with interest rate

swap, cap or floor contracts; and foreign

currency denominated debt coupled

with foreign exchange swap contracts.

Many bonds and contracts incorporate

call or cancellation options,

respectively. Enterprise funding costs

are affected by management decisions to

retire debt or cancel derivative contracts

prior to stated maturities, as well as

decisions about the characteristics of

debt issued and derivatives activities

initiated during the stress period.

Even though the initial stress test

involves a ‘‘winddown’’ of the

Enterprises’ businesses, decisions with

respect to bond calls and derivatives

contract cancellations must be

simulated. The financing of mortgages

purchased to fulfill contractual

commitments may require the issuance

of new liabilities and possibly the

initiation of new derivatives contracts.

The run-off of liabilities at a faster rate

than assets may also require new

issuances.

Question 41: What should be the

decision rules that OFHEO applies in

the stress test related to the exercise of

bond calls and derivatives contract

cancellations?

Question 42: What should be the

characteristics of simulated liabilities

issued by the Enterprises during the

stress period, e.g., maturities, option

structure, and coupon structure?

Question 43: What are the

implications for simulated liabilities of

the pattern of interest rate movements

modeled during the initial year of the

stress period?

D. Yield Curve Volatility and Option

Pricing

The Act states that the ten-year CMT

yield will be held at a constant level for

the last nine years of the stress period,35

but remains silent on the volatility of

the remainder of the Treasury yield

curve. Theoretically, the historical

volatility of the yield curve has some

bearing on expectations of future

volatility. Expectations of future

volatility, in turn, are a determinant of

the current value of a call option on

debt.

Question 44: How does OFHEO

implement the link between the

volatility of the yield curve experienced

during the stress test and the market’s

expectations of future volatility?

Question 45: What assumptions

should OFHEO make about the speed

with which the Enterprises adjust to

changes in volatility during the stress

period?

Question 46: If the actual volatility of

yields experienced during the stress test

reaches extraordinarily low levels, what

assumptions should OFHEO make to

ensure reasonable pricing and use of

call options on new debt?

E. Enterprises’ Costs of Borrowing

As any organization depletes its

capital reserves, the organization’s cost

of borrowing increases due to its higher

perceived risk. Spreads over Treasury

securities might also be affected by

other aspects of the stress period,

including the sharp interest rate changes

early in the period and the prolonged

general economic weakness.

Question 47: What techniques should

OFHEO use to project the Enterprises’

borrowing costs? How should the stress

test link capital levels and quality

spreads (borrowing rates relative to

Treasuries)?

Question 48: Should yields relative to

Treasuries widen during the stress

period in response to general interest

rate changes or credit problems? If so,

by how much should they widen?

F. Hedging Activities

Hedging activities associated with

structured notes, which convert specific

securities into a preferred debt

structure, are addressed above under

‘‘Liabilities.’’ The Enterprises engage in

other hedging activities to manage

interest rate risk more generally. The

Act provides that:

Losses or gains on other activities,

including interest rate and foreign exchange

hedging activities, shall be determined by the

Director, on the basis of available
7478 Federal Register / Vol. 60, No. 26 / Wednesday, February 8, 1995 / Proposed Rules

36Section 1361(a)(4) (12 U.S.C. 4611(a)(4)).

37Section 1361(a)(3) (12 U.S.C. 4611(a)(3)).

38 Id.

39Section 1361(b)(2) (12 U.S.C. 4611(b)(2)).

information, to be consistent with the stress

period.36

Question 49: How should OFHEO

simulate gains and losses (other than

those associated with counterparty

failures) on derivative activities in the

stress test?

G. Investment of Excess Cash

Under certain circumstances,

simulation of the stress scenarios may

require decision rules concerning the

investment of excess cash. For example,

in the stress test scenario where the ten

year CMT yield falls, mortgage

prepayments will increase. The

proceeds from prepayments of

mortgages in the retained portfolio may

exceed the cost of retiring associated

debt. Likewise, in the rising rate stress

test scenario, mortgages will prepay

more slowly than in other scenarios.

Slower prepayments may lead to the

receipt of more guarantee fee income

than initially anticipated on the

Enterprises sold portfolio because the

mortgages remain outstanding longer

than originally anticipated.

Since the Act does not permit the

simulation of new business in the initial

stress test model, any excess cash

generated during the stress test period

must be assumed to either be retained

as cash or reinvested in an interestbearing asset.

Question 50: What decision rules

should govern the investment of excess

cash during the stress period?

Question 51: What rate of interest

should excess cash be assumed to earn?

Question 52: Should excess cash be

assumed to earn a single rate or a

weighted average rate, representing a

range of possible investment choices?

H. Other Indexes and Yields

Values must be created for other

indexes and yields, e.g., the Federal

Home Loan Bank Eleventh District Cost

of Funds Index and the London

Interbank Offer Rate, over the stress

period in order to reasonably project

liability costs, as well as amortization,

prepayment, and default rates on

affected adjustable rate mortgages. One

reasonable approach might be for

OFHEO to create equations that project

these indexes based on their

relationship to points on the Treasury

yield curve and assumed market

conditions consistent with the

circumstances of the stress test.

Question 53: What techniques should

be used to simulate the behavior of

these indexes and yields?

III. New Business and Other

Considerations

OFHEO’s risk-based capital test must

incorporate a number of decision rules

to reflect management actions that

would significantly affect the financial

performance of the Enterprises during

the stress period. Initially, the Act

requires that OFHEO’s stress test

incorporate no new business for the

Enterprises during the stress period

other than the fulfillment of contractual

commitments to purchase mortgages or

issue securities.37 The Act specifically

states that:

The characteristics of resulting mortgage

purchases [and] securities issued * * * will

be consistent with the contractual terms of

such commitments, recent experience, and

the economic characteristics of the stress

period.38

The Act also requires that

characteristics of the stress period other

than those discussed above in the

‘‘Credit Risk’’ and ‘‘Interest Rate Risk’’

sections (such as, for example, dividend

policies and operating expenses) be

determined by the Director, on the basis

of available information, to be most

consistent with the stress period.39

A. Commitments

At this time, the only ‘‘new business’’

OFHEO can assume during the stress

period is the fulfillment of contractual

commitments to purchase mortgages or

issue new securities. As a regular

business practice, the Enterprises enter

into commitments to purchase

mortgages for periods that may extend

from a few weeks up to a year. The

commitments specify underwriting and

pricing criteria for the mortgages to be

delivered. If the Enterprise intends to

securitize the mortgages listed in the

commitment, then the Enterprise will

hedge the commitment at the time it is

executed by selling the mortgages

forward.

Often the seller/servicer that has

agreed to sell to an Enterprise under a

commitment has not yet originated the

mortgages at the time the commitment

is executed. When the seller/servicer

actually delivers mortgages, their

characteristics may differ from those

specified in the original commitment.

Question 54: How should OFHEO

define the term ‘‘commitments’’?

Question 55: On what basis, if any,

should OFHEO simulate the fulfillment

of outstanding commitments?

Question 56: What mix of product

types and underwriting qualities should

be assumed?

Question 57: What delivery timing

should be assumed?

Question 58: What assumptions

should be made with regard to

securitization versus retention in

portfolio?

B. Dividend Policies

During the stress period, net income

will fall, reducing cash available for

distribution to shareholders. In such

circumstances, Enterprise management

might be expected to suspend dividends

or reduce the dividend rate. However,

Enterprise management may be

reluctant to take such actions, because

dividend reductions send a negative

signal to investors and would be

expected to depress the market price of

Enterprise shares.

Question 59: Should OFHEO assume

continuation of the present dividend

policies of each Enterprise for the entire

stress period?

Question 60: If OFHEO simulates a

reduction in the dividend payout rate, at

what point in the scenario should it take

place?

Question 61: By how much should

dividends be reduced if they are

reduced?

C. Operating Expenses

The Act is silent on how operating

expenses should be treated in the stress

test, but OFHEO interprets the Act to

require that OFHEO model operating

expenses in a manner most consistent

with the stress period. Operating

expenses lower the Enterprises’ earnings

or increase their losses, and thereby

reduce their capital. The major portion

of operating expenses at each of the

Enterprises consists of costs related to

personnel, occupancy, and equipment.

Each Enterprise is divided by business

function, such as purchase of mortgages,

credit analysis, and investment

management. Each Enterprise has

regional offices. The cessation of

additional business at the

commencement of the stress period

(beyond the fulfillment of contractual

obligations) creates conditions that

would quickly eliminate some

operations and gradually reduce others.

Question 63: How should OFHEO

appropriately model operating expenses

in the stress test?

Question 64: To what extent, if any,

should operating expenses be

disaggregated and treated in distinct

categories?

Question 65: How, if at all, should the

stress test distinguish between the

Enterprises in their management of

operating expenses during the stress

period?
Federal Register / Vol. 60, No. 26 / Wednesday, February 8, 1995 / Proposed Rules 7479

Conclusion

OFHEO has identified and

highlighted many of the significant

issues that must be addressed in

connection with development of the

stress test and the associated risk-based

capital regulation. OFHEO seeks

comment on these and any additional

issues that may be identified.

The development of the stress test and

the risk-based capital regulation is one

of the critical statutory responsibilities

of OFHEO. In carrying out this

responsibility, OFHEO is committed to

a regulatory process that will provide

the broadest possible range of opinions

from the widest array of information

sources for consideration during the

regulatory process. The development of

the stress test and the implementation of

the risk-based capital regulation will

provide regulatory and analytical

standards and tools that will safeguard

the financial safety and soundness of

the Enterprises and in turn will ensure

that the Enterprises continue to

accomplish their public missions. Given

the significance of this undertaking,

OFHEO encourages all interested parties

to analyze the issues raised in this

ANPR and submit comments on the

specific questions. OFHEO will

thoroughly analyze and carefully

consider all comments during the

course of the development of the stress

test and risk-based capital regulation.

Dated: February 2, 1995.

Aida Alvarez,

Director, Office of Federal Housing,

Enterprise, Oversight.

[FR Doc. 95–3076 Filed 2–7–95; 8:45 am]

BILLING CODE 4220–01–P

DEPARTMENT OF TRANSPORTATION

Federal Aviation Administration

14 CFR Part 25

[Docket No. ANM–106; Notice No. SC–95–

2–NM]

Special Conditions: Raytheon

Corporate Jets, Inc., Model Hawker 800

Airplanes, High-Intensity Radiated

Fields

AGENCY: Federal Aviation

Administration, DOT.

ACTION: Notice of proposed special

conditions.

SUMMARY: This notice proposes special

conditions for the Raytheon Corporate

Jets, Inc., Model Hawker 800 airplanes

equipped with modifications that install

Garrett TFE731–5BR–1H engines and a

mach trim system. The configuration of

these airplanes will utilize new and

revised electronic systems that perform

functions critical to the safety of the

airplane. The applicable regulations do

not contain adequate or appropriate

safety standards for the protection of

these systems from the effects of highintensity radiated fields. These

proposed special conditions contain the

additional safety standards that the

Administrator considers necessary to

establish a level of safety equivalent to

that established by the existing

airworthiness standards.

DATES: Comments must be received on

or before March 27, 1995.

ADDRESSES: Comments on this proposal

may be mailed in duplicate to: Federal

Aviation Administration, Transport

Airplane Directorate (ANM–100), Attn:

Docket No. NM–106, 1601 Lind Avenue

SW., Renton, Washington, 98055–4056;

or delivered in duplicate to the

Transport Airplane Directorate at the

above address. Comments must be

marked: Docket No. NM–106.

Comments may be inspected in the

Rules Docket weekdays, except Federal

holidays, between 7:30 a.m. and 4:00

p.m.

FOR FURTHER INFORMATION CONTACT:

William Schroeder, FAA,

Standardization Branch, ANM–113,

Transport Airplane Directorate, Aircraft

Certification Service, 1601 Lind Avenue

SW., Renton, Washington, 98055–4056.

SUPPLEMENTARY INFORMATION:

Comments Invited

Interested persons are invited to

participate in the making of these

proposed special conditions by

submitting such written data, views, or

arguments as they may desire.

Communications should identify the

regulatory docket or notice number and

be submitted in duplicate to the address

specified above. All communications

received on or before the closing date

for comments will be considered by the

Administrator before further rulemaking

action is taken on these proposals. The

proposals contained in this notice may

be changed in light of comments

received. All comments submitted will

be available in the Rules Docket for

examination by interested persons, both

before and after the closing date for

comments. A report summarizing each

substantive public contact with FAA

personnel concerning this rulemaking

will be filed in the docket. Persons

wishing the FAA to acknowledge

receipt of their comments submitted in

response to this notice must submit

with those comments a self-addressed,

stamped postcard on which the

following statement is made:

‘‘Comments to Docket No. NM–106.’’

The postcard will be date stamped and

returned to the commenter.

Background

On February 7, 1994, Raytheon

Corporate Jets, Inc., 3 Bishop Square, St.

Albans Road West, Hatfield,

Hertfordshire AL10 9NE, England,

applied for a revision to type certificate

number A3EU to add new engines and

a mach trim system to the model

Hawker 800 series airplanes currently

included on that TC. This revised model

Hawker 800 is a crusifix tail, low wing,

15 passenger business jet powered by

two Garrett TFE 731–5BR–1H turbofan

engines mounted on pylons extending

from the aft fuselage. The engines will

be capable of delivering 4,634 lbs. of

max continuous thrust each and 4750

pounds of thrust on the operating

engine for up to 5 minutes at automatic

power reserve (APR) power.

Type Certification Basis

Under the provisions of § 21.29 of the

FAR, Raytheon must show, except as

provided in § 25.2, that the revised

Model Hawker 800 complies with the

certification basis of record shown on

TC Data Sheet A3EU for model Hawker

800 airplanes plus, for the engine and

mach trim system installations,

§ 25.1316 as amended by Amendment

25–80, § 25.933 as amended by

Amendment 25–40, § 25.934 as

amended through Amendment 25–23,

§ 25.1309 as amended through

Amendment 25–23, parts 34 and 36 of

the FAR as amended through the latest

amendment in effect at the time of

certification of this revision to the TC

and any additional equivalent safety

findings made for this revision of the

TC. The special conditions that may be

developed as a result of this notice will

form an additional part of the type

certification basis.

If the Administrator finds that the

applicable airworthiness regulations

(i.e., part 25, as amended) do not

contain adequate or appropriate safety

standards for the model Hawker 800

because of a novel or unusual design

feature, special conditions are

prescribed under the provisions of

§ 21.16 to establish a level of safety

equivalent to that established in the

regulations.

Special conditions, as appropriate, are

issued in accordance with § 11.49 of the

FAR after public notice, as required by

§§ 11.28 and 11.29, and become part of

the type certification basis in

accordance with § 21.29(a)(1)(ii) and

§ 21.17(a)(2).

Special conditions are initially

applicable to the model for which they