Congress established and chartered the enterprises—Fannie Mae and Freddie Mac—as government-sponsored enterprises (GSE) that are privately owned and operated. Their mission is to enhance the availability of mortgage credit across the nation during both good and bad economic times by purchasing mortgages from lenders (banks, thrifts, and mortgage bankers) that use the proceeds to make additional mortgage loans to home buyers. The enterprises issue debt to finance some of the mortgage assets they retain in their portfolios. Most mortgages purchased by the enterprises are conventional mortgages, which have no federal insurance or guarantees. Enterprise purchases are subject to a conforming loan limitthat currently stands at $300,700 for a single-unit home. The debt and mortgage assets in the enterprises’ portfolios are on-balance sheet obligations (liabilities) and assets, respectively. A majority of the mortgages, however, are placed in mortgage pools to support mortgage- backed securities (MBS) that may be sold to investors or repurchased by the enterprises and held in their portfolios. MBS are conduits for collecting principal and interest payments from mortgages in the mortgage pools and passing payments onto MBS investors. The enterprises charge fees for guaranteeing the timely payment of principal and interest on MBS held by investors. MBS held by investors other than the enterprises are off- balance sheet obligations of the enterprises. The federal government’s creation of and continued relationship with Fannie Mae and Freddie Mac have created the perception in financial markets that the government will not allow the enterprises to default on their debt and MBS obligations, although no such legal requirement exists. As a result, Fannie Mae and Freddie Mac can borrow money in the capital markets at lower interest rates than comparably creditworthy private corporations that do not enjoy federal sponsorship. At least a portion of the financial benefits that accrue to the enterprises have been passed along to homeowners in the form of lower mortgage interest rates. During the 1980s, the government did provide limited regulatory and financial relief to Fannie Mae when the enterprise was experiencing significant financial difficulties; and in 1987, Congress authorized $4 billion to bail out the Farm Credit System, another GSE. Recognizing the potentially large costs that Fannie Mae and Freddie Mac pose to taxpayers, Congress passed the act, which established OFHEO as an independent regulator within HUD—tasked with ensuring the enterprises’ safety and soundness. OFHEO’s director has broad independent authority to ensure that OFHEO fulfills its safety and soundness mission. For example, the director has the authority to take supervisory and enforcement actions regarding the safety and soundness of the enterprises without the review and approval of the Secretary of HUD. The act requires OFHEO to carry out its oversight function both by establishing and enforcing minimum capital standards (including the risk- based capital standard) and by conducting annual on-site safety and soundness examinations of the enterprises to assess their operations and financial condition. The act established the broad outlines of a stress test and mandated that OFHEO develop its stress test within those parameters to serve as the basis for the risk-based capital standards. The act requires the stress test to simulate situations that expose the enterprises to extremely adverse credit and interest rate scenarios over a 10-year period and to calculate the cash flows and the amount of capital the enterprises would need to continue to operate for the entire period. The stress test model must include upward and downward interest rate movements of up to 6 percentage points and assume a high level of credit risk (based on the worst cumulative credit loss for not less than 2 consecutive years in contiguous states encompassing at least 5 percent of the U.S. population). As required in the act, the stress test model that the agency developed estimates credit and interest rate risks, among other factors, and includes an additional 30 percent of that amount for management and operations risk. Also as required, it does not include new business assumptions. The act set a December 1, 1994, deadline for completion of the stress test and risk-based capital standards. HUD is the mission regulator of the enterprises. The Secretary of HUD has general regulatory power over the enterprises to ensure that they carry out their mission as stated in their charters. The act requires the Secretary to establish annual goals for purchases of mortgages on low- and moderate- income housing, special affordable housing, and housing in central cities, rural areas, and other under-served areas. When HUD establishes housing goals, it must look at several factors, including the need for the enterprises to remain in sound financial condition. For more information about HUD’s mission regulation, see appendix I. The enterprises are in the business of buying and holding mortgages and insuring mortgage cash flows to investors. New business accounts for a large share of the enterprise’s on- and off-balance sheet holdings and thus has a major impact on their activities and financial health. The financial health of the enterprises and their ability to survive a future stressful economic period depend on the level of risk in both their existing and new business; the amount of capital that is available to them to absorb any losses—their capital adequacy; and the business decisions they make during the stressful period. The enterprises continually acquire mortgages originated by lenders for home purchases and for refinancing existing mortgages (see table 1). Such mortgage acquisitions are a large share of total originations in any year and are often large relative to mortgage holdings at the end of the prior year. For example, the enterprises’ purchases equaled between 32 and 51 percent of total single-family originations in each year between 1991 and 2000. In addition, their yearly purchases between 1991 and 2000 ranged from about 17 to 51 percent of their total mortgage portfolios in the prior year. At the end of 2001, Fannie Mae’s total mortgage portfolio was $1.56 trillion and Freddie Mac’s $1.14 trillion, of which $705 billion and $492 billion, respectively, represented on-balance sheet mortgages. For more information about the financial performance of the enterprises, see appendix II. The enterprises face two primary risks, which are modeled in OFHEO’s stress test: interest rate risk and credit risk. The degree of risk depends on the enterprises’ operating and managerial decisions as well as on future economic factors such as interest rates, unemployment, inflation, and economic growth. Although the enterprises can take risk-management efforts to limit their exposure, the costs of these efforts can reduce profits. Thus, risk management is usually associated with both a lower expected or average profit and reduced variability in profits and losses. Interest rate risk reflects both movements in interest rates and management decisions about how to fund mortgage acquisitions. In general for the enterprises, when market interest rates decline, mortgage purchases increase as homeowners move and pay off or refinance existing mortgages. Declining rates may also lower the enterprises’ funding costs. In contrast, rising market interest rates create higher interest expenses for the enterprises as debt turns over. Prolonged periods of rising interest rates typically lead to a slowdown in prepayments and refinancing activity, because interest rates on new mortgages are higher than those on most of the previously originated mortgages. If funding costs rise and existing on- balance sheet mortgages at old, lower interest rates remain on the books, prolonged periods of losses and capital erosion can occur. Enterprise management can use callable debt and other financial instruments or strategies to mitigate interest rate risk and other potential losses. However, such managerial decisions will tend to lower future expected profits. OFHEO’s current stress test, which assumes no new business over a 10- year period, simulates the impact of interest rate movements and economic conditions on the behavior of borrowers whose mortgages are held by the enterprises and therefore affect the enterprises’ cash flows. The model requires that the mortgage holdings wind down over the 10- year period. The extent to which existing business winds down shows the importance of new business, because in practice the enterprises would be acquiring new mortgages to replace lost mortgages during the period. In the stress test model, the remaining mortgage balance (and existing business) depends on scheduled payments of principal, other prepayments, and defaults. Prepayments are sensitive to interest rate changes because lower rates accelerate prepayments and higher rates depress them. Default losses are sensitive to economic conditions, including loan-to-value ratios and seasoning, because loans with lower loan-to-value ratios and seasoned loans are less likely to default. OFHEO ran its model for us for a portfolio of newly originated 30-year fixed-rate single-family mortgages with 95 percent loan-to-value ratios. About 4.7 percent of a portfolio of newly originated loans would still be on the enterprises’ books after 10 years in the declining interest rate environment mandated by the act. In the increasing rate environment mandated by the act, about 57.3 percent of a portfolio of newly originated loans would still be on the enterprises’ books after 10 years. OFHEO also ran the model on other portfolios with different loan-to-value ratios and degrees of seasoning, with similar results in both the declining and increasing rate environments. As previously stated, in actual practice the enterprises would replace many of the lost loans; and the types of mortgages acquired and types of financial instruments actually used to fund these new mortgages would significantly impact returns and risks. Credit risk reflects both economic conditions and management decisions about mortgage acquisitions. Deteriorating economic conditions can lower home values and reduce homeowners’ incomes, therefore increasing credit risk. Likewise, management decisions to increase loan-to-value ratios or otherwise ease underwriting standards can raise credit risk. The OFHEO simulations also showed how the credit stresses in the mandated increasing and decreasing rate environments could affect credit- related losses.