Freddie Mac 2004 Annual Report Download - page 204

NOTE 10: REGULATORY CAPITAL
The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (""GSE Act'') established
risk-based, minimum and critical capital standards for Freddie Mac and Fannie Mae.
The risk-based capital standard determines the amount of capital that Freddie Mac must hold to absorb
projected losses resulting from future adverse interest-rate and credit-risk conditions speciÑed by the GSE
Act, plus 30 percent mandated by the GSE Act to cover management and operations risk. The risk-based
capital standard is based on stress test results calculated under two interest-rate scenarios prescribed by the
GSE Act, one in which 10-year Treasury yields rise by as much as 75 percent (up-rate scenario) and one in
which they fall by as much as 50 percent (down-rate scenario). The credit component of the stress tests
simulates the performance of Freddie Mac's mortgage portfolio based on loss rates for the Benchmark Region.
The criteria for the Benchmark Region are set forth by the GSE Act and are intended to capture the region
that experienced the highest historical rates of default and severity of mortgage losses for two consecutive
origination years. The risk-based capital requirement is the amount of Total capital needed to absorb the stress
test losses in the most adverse scenario, plus 30 percent of that amount to cover management and operations
risk. Total capital includes Core capital and general reserves for mortgage and foreclosure losses and any other
amounts available to absorb losses that OFHEO includes by regulation. Core capital consists of the par value
of outstanding common stock (common stock issued less common stock held in treasury), the par value of
outstanding perpetual noncumulative preferred stock, additional paid-in capital and retained earnings, as
determined in accordance with GAAP.
The minimum capital standard requires Freddie Mac to hold an amount of Core capital that is generally
the sum of 2.50 percent of aggregate on-balance sheet assets, as determined in accordance with GAAP, and
approximately 0.45 percent of outstanding mortgage-related securities guaranteed by Freddie Mac and other
aggregate oÅ-balance sheet obligations. As discussed below, in 2004 OFHEO implemented a framework for
monitoring Freddie Mac's capital adequacy, which includes a targeted capital surplus of 30 percent of its
minimum capital requirement.
The critical capital standard requires Freddie Mac to hold an amount of Core capital that is generally the
sum of 1.25 percent of aggregate on-balance sheet assets, as determined in accordance with GAAP, and
approximately 0.25 percent of outstanding mortgage-related securities guaranteed by Freddie Mac and other
aggregate oÅ-balance sheet obligations.
OFHEO is required to classify Freddie Mac's capital adequacy not less than quarterly.
To be classiÑed as ""adequately capitalized,'' Freddie Mac must meet both the risk-based and minimum
capital standard. If Freddie Mac fails to meet the risk-based capital standard, it cannot be classiÑed higher
than ""undercapitalized.'' Under OFHEO regulations, the company will be deemed ""signiÑcantly undercapital-
ized'' if it fails to meet the minimum capital requirement but exceeds the critical capital requirement. If
Freddie Mac fails to meet the critical capital standard, Freddie Mac must be classiÑed as ""critically
undercapitalized.'' OFHEO retains discretion to reduce Freddie Mac's capital classiÑcation by one level if
OFHEO determines that Freddie Mac is engaging in conduct not approved by OFHEO that could result in a
rapid depletion of Core capital or that the value of property subject to mortgage loans held or secured by
Freddie Mac has decreased signiÑcantly.
OFHEO has never classiÑed Freddie Mac as other than ""adequately capitalized,'' the highest possible
classiÑcation. When Freddie Mac is classiÑed as adequately capitalized, the company can generally pay a
dividend on its common or preferred stock without prior OFHEO approval so long as the payment would not
decrease Total capital to an amount less than its risk-based capital requirement and would not decrease the
company's Core capital to an amount less than the minimum capital requirement.
If Freddie Mac were classiÑed as undercapitalized, the company would be prohibited from making a
capital distribution (which includes common and preferred dividend payments, common stock repurchases
and preferred stock redemptions) that would decrease its Core capital to an amount less than the minimum
capital requirement. Freddie Mac also would be required to submit a capital restoration plan for OFHEO
approval, which could adversely aÅect its ability to make capital distributions.
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