W. Scott Frame, Kristopher Gerardi, and Paul S. Willen

Working Paper 2015-3
March 2015

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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.

JEL classification: G21, G23, G28

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

The authors thank Rosalind Bennett, Mark Flannery, Edward Golding, Andreas Lehnert, Scott Smith, Bob Triest, Geoff Tootell, and Robert Van Order for valuable suggestions. The paper has also benefited from comments received at presentations at the Federal Reserve Board, Five Bridges LLC, the Atlanta Fed's Financial Markets Conference, the Chicago Fed's Bank Structure Conference, the Joint Central Banker's Conference at the Federal Reserve Bank of Cleveland, the Inaugural Conference of the MIT Center for Finance and Policy, the Southern Economic Association, the Richmond Fed, and participants in the applied economics seminar at the Wharton School. They are indebted to Neil Desai and Ellie Terry for outstanding research assistance. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Banks of Atlanta and Boston, or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
Please address questions regarding content to W. Scott Frame, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309-4470, scott.frame@atl.frb.org; Kristopher Gerardi, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309-4470, kristopher.gerardi@atl.frb.org; or Paul S. Willen, Research Department, Federal Reserve Bank of Boston and National Bureau of Economic Research, 600 Atlantic Avenue, Boston, MA 02210 2204, paul.willen@bos.frb.org.
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