The Federal Housing Finance Agency released results of annual stress tests conducted by Fannie Mae and Freddie Mac (the Enterprises), showing that under the Severely Adverse scenario, Treasury Department draws are projected to range between $34.8 billion and $99.6 billion, depending on the treatment of deferred tax assets. Last year’s projection was between $49.2 billion and $125.8 billion.
The Dodd-Frank Act requires financial institutions with more than $10 billion in assets to conduct annual stress tests to determine whether they can absorb losses as a result of adverse economic conditions. The FHFA report, Dodd-Frank Act Stress Tests (DFAST)—Severely Adverse Scenario, provides updated information on possible ranges of future financial results of Fannie Mae and Freddie Mac under severely adverse economic conditions. The 2017 test is the fourth implementation of these tests for the Enterprises.
Severely Adverse scenario. The Severely Adverse scenario is based upon a severe global recession which is accompanied by a period of elevated stress in corporate financial and commercial real estate markets. It includes large reductions in asset prices, significant widening of corporate bond spreads, and strained market liquidity conditions.
In the 2017 DFAST Severely Adverse scenario, U.S. real GDP begins to decline immediately and reaches a trough in the second quarter of 2018 after a decline of 6.50 percent from the pre-recession peak. The rate of unemployment increases from 4.7 percent at the beginning of the planning horizon to a peak of 10.0 percent in the third quarter of 2018. The annualized consumer price inflation rate initially declines to about 1.25 percent by the second quarter of 2017 and then rises to approximately 1.75 percent by the middle of 2018.
Enterprise releases. The Enterprises also released results of their stress tests, as required by Dodd-Frank. Fannie Mae published its 2017 Annual Stress Testing Disclosure, and Freddie Mac published its 2017 Dodd-Frank Act Stress Test Severely Adverse Scenario Results.
Use of stress tests. In its Summary Instructions and Guidance document, the FHFA explains that its rule on Stress Testing of Regulated Entities (12 CFR Part 1238) requires each regulated entity to take the results of the annual stress test into account in making any changes to its capital structure (including the level and composition of capital); its exposures, concentrations, and risk positions; any plans for recovery and resolution; and to improve overall risk management. For regulated entities under FHFA conservatorship, any post-assessment actions would require FHFA’s prior approval.
Results for deferred tax assets. In its Frequently Asked Questions, the FHFA explained that in 2008 the Enterprises established a valuation allowance on DTAs, which significantly reduced their capital positions. The disclosure of results with and without the establishment of a DTA allowance eliminates the need to assess the recoverability of deferred tax assets in the Severely Adverse scenario and is provided for comparative purposes and transparency.
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