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The Failure of supervisory stress testing: Fannie Mae, Freddie Mac, and OFHEO

Author

Listed:
  • Frame, W. Scott

    () (Federal Reserve Bank of Atlanta)

  • Gerardi, Kristopher S.

    () (Federal Reserve Bank of Atlanta)

  • Willen, Paul S.

    () (Federal Reserve Bank of Boston)

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.

Suggested Citation

  • Frame, W. Scott & Gerardi, Kristopher S. & Willen, Paul S., 2015. "The Failure of supervisory stress testing: Fannie Mae, Freddie Mac, and OFHEO," Working Papers 15-4, Federal Reserve Bank of Boston.
  • Handle: RePEc:fip:fedbwp:15-4
    as

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    File URL: http://www.bostonfed.org/economic/wp/wp2015/wp1504.pdf
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    References listed on IDEAS

    as
    1. W. Scott Frame & Andreas Fuster & Joseph Tracy & James Vickery, 2015. "The Rescue of Fannie Mae and Freddie Mac," Journal of Economic Perspectives, American Economic Association, vol. 29(2), pages 25-52, Spring.
    2. Christopher L. Foote & Kristopher S. Gerardi & Paul S. Willen, 2012. "Why did so many people make so many ex post bad decisions? the causes of the foreclosure crisis," FRB Atlanta Working Paper 2012-07, Federal Reserve Bank of Atlanta.
    3. Nothaft, Frank E & Pearce, James E & Stevanovic, Stevan, 2002. "Debt Spreads between GSEs and Other Corporations," The Journal of Real Estate Finance and Economics, Springer, vol. 25(2-3), pages 151-172, Sept.-Dec.
    4. Wayne Passmore, 2005. "The GSE Implicit Subsidy and the Value of Government Ambiguity," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 33(3), pages 465-486, September.
    5. Rajdeep Sengupta, 2010. "Alt-A: the forgotten segment of the mortgage market," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 55-72.
    6. Yongheng Deng & John M. Quigley & Robert Van Order, 2000. "Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options," Econometrica, Econometric Society, vol. 68(2), pages 275-308, March.
    7. Donald P. Morgan & Stavros Peristiani & Vanessa Savino, 2014. "The Information Value of the Stress Test," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 46(7), pages 1479-1500, October.
    8. Joseph Gyourko & Joseph Tracy, 2013. "Unemloyment and Unobserved Credit Risk in the FHA Single Family Mortgage Insurance Fund," NBER Working Papers 18880, National Bureau of Economic Research, Inc.
    9. W. Scott Frame, 2010. "Estimating the effect of mortgage foreclosures on nearby property values: a critical review of the literature," Economic Review, Federal Reserve Bank of Atlanta.
    10. Ben S. Bernanke, 2010. "The supervisory capital assessment program -- one year later," Proceedings 1133, Federal Reserve Bank of Chicago.
    11. Ambrose, Brent W & Warga, Arthur, 2002. "Measuring Potential GSE Funding Advantages," The Journal of Real Estate Finance and Economics, Springer, vol. 25(2-3), pages 129-150, Sept.-Dec.
    12. Danis, Michelle A. & Pennington-Cross, Anthony, 2008. "The delinquency of subprime mortgages," Journal of Economics and Business, Elsevier, vol. 60(1-2), pages 67-90.
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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Bank Capital and Stress Tests: The Foundation of a Thriving Economy
      by Steve Cecchetti and Kim Schoenholtz in Money, Banking and Financial Markets on 2018-07-23 11:26:07

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    Cited by:

    1. An, Xudong & Cordell, Lawrence R., 2017. "Regime Shift And The Post-Crisis World Of Mortgage Loss Severities," Working Papers 17-8, Federal Reserve Bank of Philadelphia.
    2. Hirtle, Beverly & Kovner, Anna & Vickery, James & Bhanot, Meru, 2016. "Assessing financial stability: The Capital and Loss Assessment under Stress Scenarios (CLASS) model," Journal of Banking & Finance, Elsevier, vol. 69(S1), pages 35-55.

    More about this item

    Keywords

    bank supervision; stress test; model risk; residential mortgages; government-sponsored enterprises;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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