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. 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. Specifying management’s behavior would be speculative, unlike the modeling of borrowers’ behavior in the stress test. In addition, because a significant proportion of the enterprises’ mortgages either prepay or default over a 10-year period and are replaced by new business, the assumptions about new business could easily dominate the cash and capital flows in the stress test over the 10- year period. New Business Assumptions Could Dominate the Capital Requirement Under the Stress Test

To incorporate new business assumptions into its stress test, OFHEO could develop plausible scenarios for how enterprise management and the market might respond in a stressful environment, but depending on the assumptions, the capital requirement could be increased or decreased. These pillars—risk-based capital requirements (discussed in this report), market discipline, and supervisory review— should also be used to address safety and soundness oversight of the enterprises. In addition, OFHEO can use supervisory review in conjunction with the stress test to help limit the potential risks associated with new business. Fannie Mae and OFHEO provided technical comments that were incorporated where appropriate. At the end of 2001, Fannie Mae’s total mortgage portfolio was $1.56 trillion, and Freddie Mac’s was $1.14 trillion. Capital Structure of the Federal Home Loan Bank System. Government-Sponsored Enterprises: Development of the Federal Housing Enterprise Financial Regulator.
Why GAO Did This Study

GAO reviewed whether the Office of Federal Housing Enterprise Oversight (OFHEO) should incorporate new business assumptions into the stress test used to establish risk-based capital requirements. The stress test is designed to estimate, for a 10-year period, how much capital the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) would be required to hold to withstand potential economic shocks, such as sharp movements in interest rates or adverse credit conditions. Incorporating new business assumptions into the stress test would mean specifying details about the types and quality that would be acquired during the 10-year stress period, the types of funding that would be used to acquire such mortgages, and other operating and financial strategies that would be implemented by Fannie Mae's and Freddie Mac's managements.

What GAO Found

GAO found that data for the enterprises show that new business conducted over a 10-year period accounts for a large share of their on- and off-balance sheet holdings of assets and liabilities at the end of each 10-year period. Because new business represents such a large share of enterprise holdings over time, it would have a major impact on the enterprises' financial condition, risks, and capital adequacy in the face of stressful events. However, determining the appropriate new business assumptions to include in the model would be difficult and inherently speculative. with OFHEO having to develop plausible scenarios for how enterprise management and the market would respond in a stressful environment. OFHEO can use supervisory review, which includes examination of the enterprises' ongoing business activities and enforcement actions, and should work in conjunction with the capital requirement to help ensure the safety and soundness of the enterprises.