The Failure of Supervisory Stress Testing: Fannie Mae, Freddie Mac, and OFHEO

57 Pages Posted: 13 Apr 2015

See all articles by W. Scott Frame

W. Scott Frame

Federal Reserve Bank of Dallas

Kristopher Gerardi

Federal Reserve Bank of Atlanta

Paul Willen

Federal Reserve Bank of Boston - Research Department; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: March 2015

Abstract

Stress testing has recently become a critical risk management and capital planning tool for large financial institutions and their supervisors around the world. However, the one prior U.S. experience tying stress test results to capital requirements was a spectacular failure: the Office of Federal Housing Enterprise Oversight's (OFHEO) risk-based capital stress test for Fannie Mae and Freddie Mac. We study a key component of OFHEO's model — 30-year fixed-rate mortgage performance — and find two key problems. First, OFHEO had left the model specification and associated parameters static for the entire time the rule was in force. Second, the house price stress scenario was insufficiently dire. We show how each problem resulted in a significant underprediction of mortgage credit losses and associated capital needs at Fannie Mae and Freddie Mac during the housing bust.

Keywords: Bank supervision, stress test, model risk, residential mortgages, government-sponsored enterprises

JEL Classification: G21, G23, G28

Suggested Citation

Frame, W. Scott and Gerardi, Kristopher S. and Willen, Paul S., The Failure of Supervisory Stress Testing: Fannie Mae, Freddie Mac, and OFHEO (March 2015). FRB Atlanta Working Paper No. 2015-3, Available at SSRN: https://ssrn.com/abstract=2593492 or http://dx.doi.org/10.2139/ssrn.2593492

W. Scott Frame

Federal Reserve Bank of Dallas ( email )

2200 N Pearl Street
Dallas, TX 75201
United States
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Kristopher S. Gerardi (Contact Author)

Federal Reserve Bank of Atlanta ( email )

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States
404-498-8561 (Phone)

HOME PAGE: http://sites.google.com/site/kristophergerardishomepage/

Paul S. Willen

Federal Reserve Bank of Boston - Research Department ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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