Federal regulators say a formula used to calculate the amount of capital Fannie Mae and Freddie Mac must set aside to cover potential losses incorrectly assumes that the mortgage repurchasers will make a profit on some foreclosed loans.

The Office of Federal Housing Enterprise Oversight wants to change the equation to reflect the fact that the government-sponsored entities (GSEs) are unlikely to actually realize any such profits.

Although the change could restrict Fannie’s and Freddie’s future borrowing by forcing them to set aside more capital to cover potential losses, OFHEO said the GSEs were adequately capitalized in 2006 even when changes to the formula are applied retroactively.

The equation is complex, because losses on loans may include unpaid principal balance, lost interest, foreclosure costs, and expenses related to real estate-owned properties. The equation must also take into account that losses may be offset by mortgage insurance, pool-level credit enhancements, and proceeds from the sale of foreclosed properties.

The problem with the equation is connected with one term, which attempts to estimate the proceeds from the sale of a foreclosed property as a percentage of the loan amount outstanding. The estimate is calculated by dividing 61 percent — the historical recovery rate on foreclosed loans — by the estimated current loan-to-value ratio (LTV).

The formula assumes that as LTV goes down, the percentage of the outstanding loan balance that will be recovered will rise. With an estimated loan-to-value ratio of 80 percent, for example, the formula assumes a recovery rate of 76.25 percent of the value of the loan amount outstanding.

But whenever the estimated loan to value ratio falls below 61 percent, the formula assumes Fannie or Freddie will recover more than what they’re owed.

Not likely, OFHEO says, because property owners who actually have that much equity in their homes should be able to refinance. If they can’t, chances are their actual loan-to-value ratio is higher.

The formula’s weakness is its reliance on an estimated loan-to-value ratio. Since it’s too hard to plug the actual LTV for each property into the equation, the formula assumes that properties appreciate in value at the mean rate for the Census area. But if a loan is in default, chances are it has not appreciated as much as others in the area — something that’s not predicted by the model, and is only discovered when the house actually goes on the market.

“Upon foreclosure, (Fannie or Freddie) would face the challenge of selling the property in the same illiquid market, making the prospect of a profit highly unlikely,” OFHEO said in outlining its reasons for the proposed change to the formula. Profits on defaulted loans would be “unlikely in any event” because many states require extra proceeds from a foreclosure to revert to the borrower, OFHEO noted.

“The problem with the estimate of recovery proceeds has become acute, because the volume of loans in the (GSEs) portfolios with low (estimated LTVs) has increased sharply in recent years due to rapidly rising house prices,” OFHEO warned. “While only a very small percentage of loans with (low estimated LTVs) default in the … model, there are now so many loans with low (estimated LTV) values that the effects are pronounced.”

While the formula is complex, the solution is simple: Constrain the results so that “negative losses” — profits — are not allowed. In other words, the model will be allowed to predict that Fannie and Freddie might recover all of their losses foreclosing on a low-LTV loan, but not walk away with a profit.

OFHEO also proposes changing the model’s assumption that mortgage insurance is always cancelled when LTV falls below 78 percent to reflect the fact that FHA insurance remains in force.

Had the changed formula been in use during the fourth quarter of 2006, Fannie Mae’s risk-based capital requirements would have increased by between $7.5 billion and $9.8 billion, depending on interest rates. Freddie Mac’s requirements would have increased by between $4.5 billion and $5.4 billion.

Since both Fannie and Freddie had more than the required amount of capital reserves, they would not have been required to set aside additional money or reduce their debt in order to meet the requirements, OFHEO said.

Comments on the proposed rule change will be accepted for 90 days by e-mail at RegComments@OFHEO.gov. Commenters are asked to include “RIN 2550-AA38” in the subject line.

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