oversight

FHFA's Supervisory Risk Assessment for Single-Family Real Estate Owned

Published by the Federal Housing Finance Agency, Office of Inspector General on 2012-07-19.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

          FEDERAL HOUSING FINANCE AGENCY
            OFFICE OF INSPECTOR GENERAL


            FHFA’s Supervisory Risk Assessment for
              Single-Family Real Estate Owned




Audit Report: AUD-2012-005                           July 19, 2012
                                                  July 19, 2012


TO:              Jon Greenlee, Deputy Director of Enterprise Regulation




FROM:            Russell A. Rau, Deputy Inspector General for Audits



SUBJECT:         FHFA’s Supervisory Risk Assessment for Single-Family Real Estate Owned
                 (Audit Report No. AUD-2012-005)


Summary

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation (Freddie Mac) buy and sell mortgages. Typically, when borrowers default on these
mortgages and efforts to cure the defaults fail or do not materialize, the mortgages are foreclosed
upon. Through foreclosure, properties that secure the defaulted mortgages revert back to
Fannie Mae and Freddie Mac (collectively, the Enterprises) as real estate owned (REO).1

Since the onset of the financial crisis in 2007, the Enterprises have incurred substantial losses on
the mortgages they own or guarantee, and their inventories of single-family REO have grown
substantially.2 In September 2008, the Enterprises entered into conservatorships overseen by the
Federal Housing Finance Agency (FHFA or Agency). Since then, taxpayers have invested
approximately $187.5 billion to ensure the Enterprises’ solvency.3 Through 2010, there was
steady growth of the Enterprises’ REO inventories and no clear signs of price escalation in the
real estate market. As a consequence, the Enterprises are at risk of losing additional amounts on


1
 The Enterprises obtain REO properties when they are the highest bidder at foreclosure sales of properties that
collateralize mortgages that they own.
2
  From here forward, REO refers to single-family REO for simplicity and readability. Single-family properties
include those with one to four units.
3
 The Department of the Treasury provides financial support to the Enterprises by purchasing their preferred stock
pursuant to Senior Preferred Stock Purchase Agreements.


           Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
foreclosed properties and taxpayers may be called upon to provide additional money to support
them.

Since 2008, FHFA, which supervises and regulates the Enterprises and acts as their conservator,
has consistently listed their large inventories of REO as contributing to “critical concern” ratings
in their quarterly risk assessments. However, in spite of FHFA’s identification of REO as a
prominent and ascending risk, FHFA did not conduct targeted examinations or similar focused
reviews of REO until 2011.

In the second quarter of 2011, FHFA began examination planning and risk assessment work in
preparation for a supervisory review of REO management activity of the Enterprises. In June
2011, FHFA’s Office of Inspector General (FHFA-OIG) announced an audit of FHFA’s
oversight of the Enterprises’ REO. Subsequently, in July 2011, FHFA announced plans to
conduct targeted examinations of REO risks arising from the Enterprises’ use of contractors to
manage REO (e.g., appraise, maintain, sell) and their efforts to mitigate losses from problematic
properties (e.g., unmarketable homes, cancelled foreclosures). The Agency asserted that one of
the factors that prompted the targeted examinations was the Enterprises’ high-risk inventories
noted on prior risk assessments.

Completed in 2012, FHFA’s targeted examinations are positive supervisory steps that the
Agency can supplement in the future by closely assessing other REO risk areas that need focused
supervision. For example, the Enterprises also have hundreds of thousands of properties that are
in or near foreclosure (the “shadow inventory”), which may stress their systems for cost-
effectively managing, marketing, and disposing of REO. Because FHFA’s underlying risk
assessments drive the Agency’s targeted examinations, expanding the scope of the assessments
to evaluate more risks can help the Agency more comprehensively design its supervisory
planning activities for REO. In turn, gaining a more fulsome understanding of all of the risks
confronting Enterprise REO and the relative impact of such risks can help FHFA protect the
taxpayers’ investment in the Enterprises by ensuring that the Agency focuses its supervisory
resources where they may best mitigate the Enterprises’ REO-related losses.

Background

       Overview of Enterprises’ REO

The Enterprises support the secondary mortgage market by purchasing residential mortgage
loans from sellers that can then use the proceeds to make more loans. They may hold the
purchased mortgages as their own investments or bundle them into mortgage-backed securities
(MBS) in which the underlying loans are guaranteed in the event they default. MBS are then
sold to other investors. The Enterprises suffer losses when inadequately collateralized mortgages
go into default and they either own the loans or they have guaranteed them as part of an MBS
transaction. The Enterprises try to minimize these losses by taking ownership (through
          Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
                                                     2
foreclosure and other means) of the properties securing the defaulted mortgages and then
disposing of them cost effectively.4 These foreclosed properties are referred to as REO.

In recent years, REO has grown substantially. From 2007 through 2011, the Enterprises went
from acquiring nearly 72,000 REO properties per year to over 298,000, and inventory (i.e., the
number of REO properties on hand at the end of the year) rose from over 48,000 to over
179,000.5 At the same time, the Enterprises recorded $649 million in REO-related expenses in
2007, which more than doubled to $1.4 billion in 2011. (These expenses include costs to repair,
maintain, manage, and dispose of the properties.) Although FHFA expects the risk of loss to be
mitigated to some degree by decreased REO inventory, continued steady disposition rates, and
cost efficiencies in the scale of REO operations, the Enterprises have substantial assets at risk
with such large REO inventories and associated expenses.

           Enterprises’ REO Risks

In terms of costs and community impact, REO is a high-risk area.6

One measure of the Enterprises’ financial risk derives from estimates of the size of the expected
loss on each REO property (referred to as the severity rate).7 As REO inventories have climbed,
so have the severity rates and loss estimates. For instance, from 2007 through 2011, Fannie
Mae’s reported severity rate estimates more than tripled from 11% to 35%. That is, at the end of
2007, the Enterprise expected to lose on average $22,000 on a $200,000 defaulted mortgage loan
balance, but, at the end of 2011, it expected to lose approximately $70,000 on the same loan
balance. Over the same time, Freddie Mac’s estimated severity rate similarly increased from
18% to 41%.8


4
  Foreclosure is the legal process by which the owner of a debt secured by real property can exercise his/her rights
against the property to satisfy the debt. For more information, see FHFA-OIG, An Overview of the Home
Foreclosure Process, available at
http://www.fhfaoig.gov/Content/Files/SAR%20Home%20Foreclosure%20Process.pdf.
5
  The Enterprises’ strategies for keeping people in their homes include home retention solutions and foreclosure
alternatives (e.g., loan modifications). Their strategies for disposing of REO properties consist primarily of standard
retail sales but also include alternative sale channels, such as auction sales, bulk sales to investors, public entity
sales, and rent and hold.
6
  For a more detailed discussion of the risks posed by the Enterprises’ REO inventories, including fraud,
management, and maintenance and Fannie Mae’s pilot program to sell investors foreclosed properties in bulk for
rentals, see FHFA-OIG, Overview of the Risks and Challenges the Enterprises Face in Managing Their Inventories
of Foreclosed Properties, available at http://www.fhfaoig.gov/Content/Files/WPR-2012-003.pdf.
7
 Other factors determining severity rates include price depreciation, state redemption laws, mortgage insurance
curtailments, and market-related holding periods.
8
    Percentage is based on quarterly averages for the fourth quarter of 2007 and the fourth quarter of 2011.


              Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
                                                            3
Aggravating the increased severity rates, the Enterprises risk having to acquire even more REO
inventory than they currently manage. Currently, the Enterprises own or guarantee over one
million seriously delinquent loans—loans for which payments have ceased but a foreclosure
action has not been completed. Fannie Mae recently noted that: (1) in the third quarter of 2011,
approximately 11 million, or 22%, of all residential properties with mortgages were underwater
(i.e., a property is worth less than the balance of the mortgage it secures); and (2) despite signs of
stabilization and improvement, 1 out of 13 borrowers was delinquent or in foreclosure during the
fourth quarter of 2011.9 These facts point to the likelihood of continued high REO inventories.

Beginning in 2007, the housing crisis flooded the Enterprises’ servicers with defaulted
mortgages, which led to flawed foreclosure practices. Correcting these practices was a factor
that lengthened the time between mortgages going into default and becoming Enterprise REO.
For example, between 2009 and 2011, Freddie Mac’s nationwide average for completing a
foreclosure rose from 370 days to 506 days. This increase has led to an unprecedented level of
severely delinquent mortgages (e.g., mortgages that have not had a mortgage payment for over
six months).

As shown in Figure 1 on the next page, there were over 837,000 mortgages as of December 31,
2011, on which payments had not been made for more than 6 months—over 4.5 times more than
the Enterprises’ REO inventory for 2011. Properties securing such severely delinquent
mortgages are known as “shadow inventory” because, although they do not belong to the
Enterprises yet, they are likely to become REO as the Enterprises’ servicers foreclose on them.
Further, counting only mortgages that have not been paid for over a year (i.e., 558,761), the
Enterprises still face tripling their 2011 inventory (i.e., 179,063).




9
    Fannie Mae, “Residential Mortgage Market,” Fannie Mae 2011 10K.


             Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
                                                        4
                                    Figure 1: Enterprises’ REO Properties and Shadow Inventory at
                                                          December 31, 201110

                                   900,000
                                   800,000
                                                                                      Loans 365+ Days Delinquent
           # of Loans/Properties



                                   700,000                                            (558,761)
                                   600,000
                                                                                      Loans 180-364 Days Delinquent
                                   500,000                                            (278,472)
                                   400,000
                                                                                      REO Properties (179,063)
                                   300,000
                                   200,000
                                   100,000
                                        0
                                             REO Inventory   "Shadow Inventory"

At the end of 2011, the Enterprises expected that they could suffer additional losses of over
$110 billion due largely to high severity rates and the volume of seriously delinquent loans that
may transform into foreclosures.11 And, if the housing market weakens, the Enterprises could be
exposed to larger losses. For example, 2011 ended with the Enterprises estimating that a 5%
decline in nationwide home prices could increase their losses by over $28 billion.12

Communities also face risks as the Enterprises foreclose on and then sell REO properties. For
example, the Government Accountability Office (GAO) recently cited a study estimating that
foreclosures could bring down neighboring home values by up to 8.7%.13 GAO has also noted
that the longer a foreclosure takes, the more likely a property is to be vacant during and after the
process, which leaves it open to being vandalized or used for criminal activity.14 Thus, the


10
   Source: FHFA, Foreclosure Prevention and Refinance Report, Fourth Quarter 2011, at 44 and 45, available at
http://www.fhfa.gov/webfiles/23522/4q11_fpr_finalv2i.pdf.
11
   The $110 billion here is included in the $187.5 billion Treasury investment to support the Enterprises. The figure
is drawn from the Enterprises’ single-family loan loss reserves, which are an estimate of future losses required by
accounting principles. See Fannie Mae 2011 10K, available at
http://www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2011/10k_2011.pdf; see also Freddie Mac
2011 10K, available at http://www.freddiemac.com/investors/er/pdf/10k_030912.pdf.
12
  Fannie Mae, “Regulatory Hypothetical Stress Test Scenario,” Fannie Mae 2011 10K; and Freddie Mac, “Credit
Risk Sensitivity,” Freddie Mac 2011 10K.
13
  GAO, Vacant Properties: Growing Number Increases Communities’ Costs and Challenges (November 2011);
and Frame, Scott W., “Estimating the Effect of Mortgage Foreclosures on Nearby Property Values: A Critical
Review of the Literature,” Federal Reserve Board Bank of Atlanta Economic Review, vol. 95, no. 3, 2010.
14
     GAO, Vacant Properties: Growing Number Increases Communities’ Costs and Challenges.


                            Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
                                                                       5
average foreclosure timeline of over a year sets the stage for property deterioration and
community blight.15

Overall, the Enterprises’ effectiveness in acquiring, maintaining, and disposing of REO
properties can help to mitigate risks of deterioration of vacant properties after foreclosure sale.
To support Enterprise efforts, FHFA conducts a regular cycle of risk assessment, supervisory
planning, and supervision activities.

        FHFA’s Supervision Framework

The Housing and Economic Recovery Act of 2008 established FHFA as the Enterprises’
prudential regulator to ensure that they operate in a safe and sound manner. Starting in
September 2008, Treasury began to invest taxpayer dollars in the Enterprises to prevent their
insolvency, and it has invested $187.5 billion through March 31, 2012. Concurrent with
Treasury’s support, FHFA became the conservator of the Enterprises and in that capacity it
oversees Enterprise operations with the goal of conserving and preserving assets.

To meet its mandated missions, FHFA has developed a supervision process that lays out how it
assesses the quantity of the Enterprises’ risk and the quality of their systems to manage it. In
total, FHFA’s review is intended to determine how effectively the Enterprises identify, measure,
monitor, and control risk. Each step in the supervisory process has a corresponding deliverable.

                  Figure 2: FHFA’s Supervision Steps and Resulting Products16

                    Supervisory Process Step                       Supervision Product
                Understanding the Enterprise                  Business Profile

                Planning                                      Supervision Workplan

                Performing Supervisory Activities             Continuous Supervision
                                                              Targeted Examination
                                                              Supervisory Analysis
                                                              Remediation Activities




15
  Recently, several localities have adopted ordinances to expand the responsibilities and liability for maintaining
vacant properties. The Enterprises and FHFA have reported that these ordinances could significantly increase their
costs, and the Agency has challenged at least one of them. See, e.g., FHFA, FHFA Sues the City of Chicago Over
Vacant Buildings Ordinance, available at http://www.fhfa.gov/webfiles/22832/Chicago_Lawsuit_121211.pdf.
16
  Source: FHFA Division of Enterprise Regulation’s Supervision Handbook 2.1, “The Supervision Process and
Products,” ch. 4, pgs. 35-43.


           Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
                                                         6
                Communicating                                 Mid-Year Letter
                                                              Conclusion Letter
                                                              Matters Requiring Attention
                                                              Supervisory Letter
                                                              Report of Examination
                                                              Report to Congress

                Assigning Ratings                             Risk Assessment




As shown in Figure 2 above, FHFA’s risk-based supervision begins with understanding each
Enterprise’s characteristics and condition by identifying and concentrating on its major risk
areas; this includes developing a business profile to capture the Enterprise’s structure, culture,
risk tolerance, etc.17 FHFA’s supervision process then requires that it plan how it will supervise
the Enterprise generally. This workplan is intended to guide Agency examiners to create
detailed supervision strategies (i.e., workplans) that outline comprehensive supervisory activities
to be conducted over 12 months.

According to FHFA’s Supervision Handbook, workplans are dynamic and should respond to
internal factors (e.g., business profile) and external ones (e.g., economic circumstances). As
supervision progresses over time, workplans also link FHFA’s overall risk assessment for each
Enterprise, including significant risks and supervisory concerns, to the supervisory activities that
follow. In other words, if the assessment identifies a risk or concern, the workplan must indicate
what supervisory activities will address it.

In turn, the Agency’s supervisory activities contribute to assessing an Enterprise’s risks. For
example, targeted examinations offer detailed evaluations of specific risks or risk management
systems particular to a single area, certain supervisory concern, etc. Similarly, continuous
supervision encompasses a wide range of ongoing activities to monitor and analyze emerging
trends and associated risks. Thus, along with supervisory analyses (i.e., research to improve
FHFA’s risk assessment) and remediation (i.e., oversight of an Enterprise’s corrective action), all
supervisory activities proceed through a continuous cycle of risk assessment and planning. In
particular, they share the function of discovery in which they focus extensively on risk in order



17
  Figure 2 is a linear depiction that is intended to illustrate the variety of products that comprise FHFA’s
supervisory process. It does not, however, reflect the circular nature of the supervision products and process.
Figure 3 on the next page and the text that follows Figure 2 describe how—as time progresses—supervisory
products from a prior year inform planning and products in subsequent years. Accordingly, FHFA’s Supervision
Handbook specifies that a comprehensive risk assessment—the final item of Figure 2’s linear depiction—of an
Enterprise should be used as a blueprint for planning supervisory activities—the second item of Figure 2’s linear
depiction. See FHFA Division of Enterprise Regulation’s Supervision Handbook 2.1, “Assigning Ratings,” ch. 4,
pg. 40.


           Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
                                                         7
to help Agency examiners identify, quantify, and evaluate it as the basis for planning future
supervisory activities.

As illustrated in Figure 3 below, risk assessments, supervisory planning, and supervisory
activities answer and inform each other on FHFA’s ongoing supervision program.

                       Figure 3: FHFA’s Risk-Based Supervisory Program18

                                   Supervision Planning and
                                   the Supervision Workplan

                               The supervision workplan is a link
                                    between the overall risk
                                assessment and the supervisory
                                   activities to be conducted.




            Risk Assessments                                      Supervisory Activities

      Risk assessments articulate a                             Supervision is designed to
      current understanding of the                            determine the condition of the
     Enterprises’ risks and serve as a                         Enterprises, identify areas in
      blueprint for planning future                           need of corrective action, and
          supervisory activities.                               prepare a risk assessment.




                                                                             Communicate Supervisory
                                                                                  Conclusions
                                                                          FHFA communicates supervision
                                                                               conclusions and matters
 FHFA’s Enterprise supervisory program was established to                 requiring attention in conclusion
 examine the overall safety and soundness of the Enterprises.              letters and the annual report of
                                                                                    examinations.




18
  Source: FHFA-OIG’s analysis of FHFA Division of Enterprise Regulation, Supervision Handbook 2.1, “The
Supervision Process and Products,” ch. 4, pgs. 35-43.


            Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
                                                       8
         FHFA’s Supervision of Enterprises’ REO Risk

FHFA has not effectively employed its supervision process in the REO context. As FHFA
conducted risk assessments of the Enterprises between 2008 and 2011, the Agency noted their
large inventories of REO as contributing to a “critical concern” rating—the Agency’s most
severe. 19 Until 2011, however, the Agency’s supervisory planning did not include targeted
oversight activities to examine REO-related risks (but FHFA’s supervision included general
ongoing monitoring). Specifically, FHFA did not perform any targeted examinations of the
Enterprises’ management and marketing of REO until 2011.20

In the second quarter of 2011, FHFA incorporated REO into its preliminary scoping project to
identify the need and begin planning for targeted examinations. The Enterprises use vendors for
a variety of their principal business activities, such as underwriting (i.e., determining eligibility
for mortgage loans), servicing Enterprise mortgage loans (e.g., collecting payments), information
technology (e.g., accounting software), and REO management (e.g., maintenance, real estate
sales). The preliminary scoping project’s analysis reviewed these various business activities to
identify risks specific to each area’s vendors. REO was a component, not the focus, of the
overall analysis.

Later, in the second quarter of 2011—shortly after FHFA-OIG announced this review, the
Agency’s supervisory strategy listed REO among a number of risk elements that required
monitoring.21 Afterwards, FHFA conducted four targeted examinations that were completed in
2012: two of the examinations focused on REO risks arising from the Enterprises’ use of
vendors to manage REO (e.g., appraise, maintain, sell, etc.); and two of the examinations looked
at their efforts to mitigate losses from problematic properties (e.g., unmarketable homes,
cancelled foreclosures, etc.).

Although these targeted examinations focused on some risks associated with REO, FHFA-OIG
found that FHFA’s risk assessments, which serve as the blueprint for future examination
activities, could be improved to provide coverage of additional REO risk areas. The Office of


19
   Other factors contributing to the critical concern risk rating included the high number of seriously delinquent
loans, home value depreciation, and losses relative to past performance.
20
   In 2007, FHFA’s predecessor agency, the Office of Federal Housing Enterprise Oversight, followed up on REO-
related issues identified during an earlier examination in 2005, but FHFA did not conduct a targeted examination
until 2011.
FHFA did not perform REO examinations prior to 2011 due to examiner shortfalls. Further, two of FHFA’s four
targeted examinations in 2011 were contracted out.
21
   FHFA’s Division of Enterprise Regulation, 2011 Supervisory Strategy for Fannie Mae and Freddie Mac, pg. 4
(July 2011).


           Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
                                                           9
the Comptroller of the Currency has published a handbook, Other Real Estate Owned, that
identifies various factors that impact bank REO holdings.22 These factors include:

        The property’s carrying value relative to its appraised value, asking price, and offers
         received;
        The length of time the property has been on the market and local market conditions for
         the type of property involved (e.g., recent sales trends and histories for comparable
         properties);
        Past performance in liquidating assets acquired in satisfaction of debts previously
         contracted;
        Income generated by the property and other economic factors affecting the probability of
         loss exposure;
        The manner in which the entity intends to dispose of the property;
        The source and quality of the appraisal; and
        Other pertinent factors, including the title, statutory redemption privileges, zoning, other
         liens, tax status, and insurance.

FHFA’s four targeted examinations have not addressed all of the risk factors included in the
Office of the Comptroller of the Currency’s handbook.

         FHFA-OIG’s Audit and Evaluation Strategy for FHFA’s Supervision of REO

In June 2011, FHFA-OIG announced this audit to examine the general supervisory system
underlying FHFA’s supervision of the Enterprises’ REO. This report is part of FHFA-OIG’s
multi-pronged audit and evaluation strategy for REO that includes:

        Contract audits to evaluate in more detail the Enterprises’ management of REO and
         FHFA’s oversight;
        An evaluation of FHFA’s and Fannie Mae’s REO pilot program to sell foreclosed
         properties in bulk for rentals, if it is permanently implemented; and
        A potential evaluation of specific phases of REO management, such as the Enterprises’
         REO performance measures (e.g., length of time to sell) and how their handling of REO
         affects communities.23




22
   Available at http://www.occ.treas.gov/publications/publications-by-type/comptrollers-handbook/oreo1.pdf,
section 219. Similar guidance has been issued by the Federal Reserve, see Commercial Bank Manual, Section 2200
(April 2010), available at http://www.federalreserve.gov/boarddocs/supmanual/cbem/2000.pdf.
23
   See also FHFA-OIG, Overview of the Risks and Challenges the Enterprises Face in Managing Their Inventories
of Foreclosed Properties, available at http://www.fhfaoig.gov/Content/Files/WPR-2012-003.pdf .


           Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
                                                      10
Altogether, FHFA-OIG believes this strategy will put it in position to determine if FHFA is
ensuring the Enterprises are effectively minimizing REO’s costs and community impact. In
context of FHFA-OIG’s overall strategy, this report focuses on the main precursor that drives
FHFA’s specific supervisory activities for REO: a comprehensive risk assessment.

Audit Objective

This performance audit’s objective was to assess FHFA’s supervision of the Enterprises’
management and marketing of REO properties. To accomplish this, FHFA-OIG conducted a
broad review of FHFA’s general supervision of the Enterprises’ REO.

Finding: FHFA’s Supervision of Enterprise REO Can Be Strengthened by More
         Comprehensive Risk Assessments

FHFA will benefit from a more comprehensive REO risk assessment and from using the
assessment to enhance its planning of supervisory activities. According to FHFA’s Supervision
Handbook, risk assessment is the process of developing a comprehensive, risk-focused view of
an Enterprise that presents a current look at its emerging and existing risk characteristics. The
handbook specifies that the comprehensive, risk-focused view of an Enterprise should be used as
a blueprint for planning supervisory activities.24 And, thorough planning should help Agency
examiners develop detailed strategies to supervise the Enterprises.25

However, until early in 2011, FHFA’s supervisory planning did not focus on the significant and
increasing risks associated with the Enterprises’ REO.26 Moreover, although FHFA announced
targeted examinations in July 2011, the Agency’s prior risk assessments were not sufficiently
detailed to provide a blueprint for developing subsequent supervisory activities covering the full
range of risks associated with REO beyond vendor management.27

For instance, FHFA followed up on its preliminary scoping of Enterprise-wide vendor
management risk by examining risks related to REO vendors.

          Two of FHFA’s four targeted examinations looked at the Enterprises’ management of
           their REO contractors and included reviewing REO contractors’ roles in loss mitigation

24
     FHFA Division of Enterprise Regulation, Supervision Handbook 2.1, “Assigning Ratings,” ch. 4, pg. 40.
25
     FHFA Division of Enterprise Regulation, Supervision Handbook 2.1, “Planning,” ch. 4, pg. 37.
26
   FHFA staff responsible for REO supervision emphasized that they had been tasked with analyzing proposals to
stabilize the Enterprises after the housing market crisis in 2007, which left them without time and staff to conduct
granular REO oversight activities such as targeted examinations.
27
  The Agency stated it introduced new ongoing monitoring in May 2012 that will cover foreclosure sales and REO
acquisition, as well as inventory.


             Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
                                                          11
         and evaluating policies and procedures governing REO. FHFA found deficiencies at the
         Enterprises, including decentralized complaint tracking, insufficient quality assurance
         reviews, and limited background checks of listing brokers.

        The other two examinations evaluated the Enterprises’ overall REO operations with
         respect to loss mitigation; specifically, unable-to-market inventory, aged evictions, and
         cancelled foreclosures. One Enterprise’s examination found concerns, such as
         insufficient documentation for inventory it could not market. And the complementary
         examination found key deficiencies at the other Enterprise, such as the absence of a
         comprehensive framework for managing unmarketable inventory.

Although the Agency’s efforts to examine REO contractor performance are noteworthy,
broadening the scope of its risk assessments can further enhance its supervision by ensuring that
it has accounted for other types of risk particular to REO when it plans future supervisory
activities such as targeted examinations. For example, the Office of the Comptroller of the
Currency’s guidance offers several critical risk factors beyond inventory level to consider in
coming to a comprehensive assessment of REO risk, including:

        Sales and insurance proceeds and rental income generated by the property and other
         economic factors affecting the probability of loss exposure. As discussed above, the
         Enterprises expect severity rates to remain high. Freddie Mac’s expected loss per REO
         property more than doubled while Fannie Mae’s more than tripled. At the same time, the
         Enterprises are threatened by a large shadow inventory (up to four and a half times their
         current REO inventory), which can escalate their losses even more. These potential
         losses may mount given the Federal Reserve Board’s analysis of foreclosed properties
         pulling down housing prices, which means that the Enterprises may generate less per
         property—the severity rates may increase even more as they list more foreclosed
         properties for sale.28

        The length of time the property has been on the market and local market conditions for
         the type of property involved (e.g., recent sales trends and histories for comparable
         properties). The Enterprises’ REO risks may not be distributed evenly throughout the
         nation. In 2011, over half of the Enterprises’ total credit losses (largely associated with
         disposing of single-family REO) were concentrated in four states (Arizona, California,
         Florida, and Nevada). Moreover, although Florida accounted for 12,618 REO properties,
         or 7% (i.e., 12,618 of 179,063) of the Enterprises’ total REO inventory through 2011, the
         State had 30% (i.e., 166,443 of 558,761) of the Enterprises’ loans that were 365 or more

28
  Federal Reserve Board, The U.S. Housing Market: Current Conditions and Policy Considerations, available at
http://www.federalreserve.gov/publications/other-reports/files/housing-white-paper-20120104.pdf.


           Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
                                                      12
         days seriously delinquent at the end of 2011. In other words, the Enterprises could nearly
         double their current REO inventory from Florida alone as foreclosures proceed there.
         Regional risks such as these may warrant assessment to determine if they should be
         subject to particular supervisory planning and activities.

Although not exhaustive, the Office of the Comptroller of the Currency’s guidance offers a more
comprehensive approach to assessing REO risk than merely identifying the overall level of the
Enterprises’ inventories.29

To recap, by the end of 2011, the Enterprises held over 179,000 single-family REO properties,
which were valued at over $15 billion. The losses to date on these properties and the
Enterprises’ other operations have required a taxpayer investment of $187.5 billion.
Additionally, over one million Enterprise-owned and -guaranteed mortgages are in the
foreclosure process or seriously delinquent and in danger of foreclosure. A more comprehensive
assessment of the risks associated with this real and shadow REO inventory can help FHFA
provide for the Enterprises’ safety and soundness and help protect the taxpayers from undue
losses by ensuring the Agency focuses its supervision where it can best mitigate risks.

Recommendation

FHFA-OIG recommends that FHFA’s Deputy Director of Enterprise Regulation implement the
performance of risk assessments of REO that are more comprehensive and link the results to
supervisory plans that address those risks through specific supervisory activities.

FHFA Comments

As shown in the attached appendices, FHFA agreed with FHFA-OIG’s recommendation and is
planning to take responsive corrective action.

Scope and Methodology

The audit scope was June 1, 2009, through May 31, 2011, and was expanded as necessary.

To understand how FHFA supervised the Enterprises’ REO management and marketing, FHFA-
OIG reviewed the Agency’s and the Enterprises’ relevant policies and procedures and
interviewed officials at:

        FHFA’s offices in Washington, D.C.;

29
  Additional procedures for assessing REO risk factors have also been issued by: the Federal Deposit Insurance
Corporation (Risk Management Manual of Examination Policies, sec. 3.6 “Other Real Estate,” March 2012); and the
Federal Reserve Board (Commercial Bank Examination Manual, sec. 2200.1 “Other Real Estate Owned,” April
2010).


           Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
                                                      13
        Fannie Mae’s corporate office in Washington, D.C.;
        Freddie Mac’s corporate office in McLean, Virginia; and
        Fannie Mae’s and Freddie Mac’s REO offices in Dallas, Texas.30

FHFA-OIG also reviewed computer-processed and hardcopy data from FHFA and the
Enterprises. This included: (1) FHFA’s data in its document repository and emails; and (2) the
Enterprises’ data that was electronically transmitted to FHFA-OIG via a secure website or email.
FHFA-OIG assessed the validity of the electronic and hardcopy data and found it to be generally
accurate, but could not conclude on its completeness. FHFA-OIG used this data for
informational purposes and did not rely on it to achieve the audit’s objective.

FHFA-OIG assessed the internal controls related to the audit’s objective. Internal controls are an
integral component of an organization’s management. They provide reasonable assurance of:
(1) effective and efficient operations; (2) reliable financial reporting; and (3) compliance with
applicable laws and regulations.

Internal controls relate to management’s plans, methods, and procedures for meeting its mission,
goals, and objectives. They include the processes and procedures for planning, organizing,
directing, and controlling program operations along with the systems for measuring, reporting,
and monitoring program performance. Based on the work completed in this performance audit,
FHFA-OIG considers its finding on FHFA’s supervision of the Enterprises’ REO to be
significant within the context of the audit’s objective. Additionally, other less significant matters
that came to FHFA-OIG’s attention during the audit were communicated separately to FHFA in
an audit memorandum.

FHFA-OIG conducted this performance audit from June 2011 through September 2011 in
accordance with Generally Accepted Government Auditing Standards. Those standards require
that audits be planned and performed to obtain sufficient, appropriate evidence to provide a
reasonable basis for FHFA-OIG’s finding and conclusion based on the audit objective. FHFA-
OIG believes that the evidence obtained provides a reasonable basis for the finding and
conclusion included herein, based on the audit objective.




30
  This audit was not intended or designed to assess the effectiveness of the Enterprises’ oversight of REO. FHFA-
OIG visited the Enterprises’ REO offices in Dallas, Texas for further understanding of their REO processes.


           Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
                                                       14
cc:   Edward DeMarco, Acting Director
      John Major, Internal Controls and Audit Follow-Up Manager
      Bruce Crandlemire, Senior Advisor for IG Operations

Attachments: Appendix A, FHFA’s Comments on the Finding and Recommendation
             Appendix B, FHFA-OIG’s Response to FHFA’s Comments
             Appendix C, Summary of Management’s Comments on the Recommendation




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Appendix A: FHFA’s Comments on the Finding and
Recommendation




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Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
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Appendix B: FHFA-OIG’s Response to FHFA’s Comments
On June 21, 2012, FHFA provided comments to a draft of this report, agreeing with the
recommendation and identifying FHFA actions to address it. FHFA-OIG considers the
Agency’s proposed actions sufficient to resolve the recommendation, which will remain open
until FHFA-OIG determines that agreed upon corrective actions are completed and responsive to
the recommendation. FHFA-OIG has attached the Agency’s full response (see Appendix A),
which was considered in finalizing this report. Appendix C provides a summary of
management’s comments on the recommendation and the status of agreed-to corrective actions.




         Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
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Appendix C: Summary of Management’s Comments on the
Recommendation
This table presents the management response to the recommendation in FHFA-OIG’s report and
the status of the recommendation as of when the report was issued.




                                                         Expected
    Rec.                                                Completion       Monetary      Resolved:a      Open or
    No.      Corrective Action: Taken or Planned            Date         Benefits      Yes or No       Closedb
     1.    FHFA will address the recommendation          6/30/2013         $0             Yes           Open
           by enhancing the program for
           supervision of the Enterprises in the
           following ways:

           (A) Clarify the risk factors to be
               considered by examiners in
               reviewing REO-related risks and
               preparing risk assessments; and
           (B) Ensure that REO risk assessments
               are more explicitly incorporated
               into the supervisory planning
               process, as set forth in revised
               supervisory planning procedures.

a
 Resolved means: (1) Management concurs with the recommendation, and the planned, ongoing, or completed
corrective action is consistent with the recommendation; (2) Management does not concur with the recommendation,
but alternative action meets the intent of the recommendation; or (3) Management agrees to the FHFA-OIG
monetary benefits, a different amount, or no amount ($0). Monetary benefits are considered resolved as long as
management provides an amount.
b
  Once FHFA-OIG determines that the agreed-upon corrective actions have been completed and are responsive, the
recommendation can be closed.




           Federal Housing Finance Agency Office of Inspector General • AUD-2012-005 • July 19, 2012
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ADDITIONAL INFORMATION AND COPIES


For additional copies of this report:

      Call the Office of Inspector General at: (202) 730-0880

      Fax your request to: (202) 318-0239

      Visit our website at: www.fhfaoig.gov



To report alleged fraud, waste, abuse, mismanagement, or any other kind of criminal or
noncriminal misconduct relative to FHFA’s programs or operations:

      Call our Hotline at: (800) 793-7724

      Fax your written complaint directly to: (202) 318-0385

      Email us at: oighotline@fhfaoig.gov

      Write to us at:    FHFA Office of Inspector General

                          Attn: Office of Investigation – Hotline
                          400 7th Street, SW
                          Washington, DC 20024




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