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

55 Pages Posted: 19 Oct 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: 2015-03-01

Abstract

In the aftermath of the global financial crisis, policymakers in the United States and elsewhere have adopted stress testing as a central tool for supervising large, complex, financial institutions and promoting financial stability. Although supervisory stress testing may confer substantial benefits, such tests are vulnerable to model risk. This paper studies the risk-based capital stress test conducted by the Office of Federal Housing Enterprise Oversight (OFHEO) for Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) that are central to the U.S. housing finance system. This research aims to identify the sources of the stress test's spectacular failure to detect the growing risk and ultimate financial distress at these GSEs as mortgage market conditions deteriorated in 2007 and 2008. The analysis focuses on a key element of OFHEO's stress test, the models used to predict default and prepayment of 30-year fixed-rate mortgages.

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 (2015-03-01). FRB of Boston Working Paper No. 15-4, Available at SSRN: https://ssrn.com/abstract=2675697

W. Scott Frame (Contact Author)

Federal Reserve Bank of Dallas ( email )

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Kristopher S. Gerardi

Federal Reserve Bank of Atlanta ( email )

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

Paul S. Willen

Federal Reserve Bank of Boston - Research Department ( email )

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Boston, MA 02210
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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