oversight

FHFA's Oversight of the Enterprises' Management of High-Risk Seller/Servicers

Published by the Federal Housing Finance Agency, Office of Inspector General on 2012-09-18.

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

        FEDERAL HOUSING FINANCE AGENCY
     FA’s Oversight of Enterprises’ Management of High-
           OFFICE OF INSPECTOR GENERAL
           Risk Seller/Servicer Counterparty Risk

     FHFA’s Oversight of the Enterprises’ Management of
                High-Risk Seller/Servicers




Audit Report: AUD-2012-007                   September 18, 2012
                                                 AT A GLANCE
                                                 title
                         FHFA’s Oversight of the Enterprises’ Management of
                                      High-Risk Seller/Servicers
Why FHFA-OIG Did This Audit                                     FHFA’s 2012 draft examination manual provides guidance to
The Federal National Mortgage Association (Fannie Mae)           Agency examiners concerning how to review contingency plans.
                                                                title
and the Federal Home Loan Mortgage Corporation                  FHFA has been field testing the draft manual and expecting that
(Freddie Mac) buy mortgages from lenders, such as               the Enterprises will develop contingency plans after learning
banks, and primarily rely on servicing companies for post       that the Agency instructs its examiners to look for plans during
origination mortgage-related work, such as collecting           examinations. However, although the Agency recently asked
payments. Further, it is common for the same company            the Enterprises to develop such plans as part of FHFA’s
to sell and service the loans that Fannie Mae and Freddie       supervisory process, the Agency has not published guidance
Mac (collectively, the Enterprises) purchase.                   requiring them to do so or governing their contents.
The Enterprises monitor counterparties (e.g., sellers           Accordingly, as of April 2012, the Enterprises had not
and/or servicers) that they have identified as representing     developed comprehensive contingency plans for any of their
a high-risk for concerns such as the counterparties’            more than 300 high-risk counterparties.
financial health. As of the third quarter of 2011, the          Counterparty contingency plans will not eliminate losses, but
Enterprises had placed more than 300 high-risk                  they can help reduce the Enterprises’ risk exposure. Although
counterparties on watch lists and stopped doing business        FHFA-OIG saw examples of steps the Enterprises took to lower
with more than 40 of them. In 2009, a large                     financial risk exposure associated with particular counterparties,
seller/servicer for Freddie Mac collapsed, which led the        Fannie Mae and Freddie Mac have no comprehensive strategy.
Enterprise to file a $1.8 billion claim against its             Consequently, FHFA-OIG identified at least one instance in
bankruptcy estate. Since 2008, the Enterprises estimate         which an Enterprise increased its exposure and business volume
that they incurred losses of up to $6.1 billion from failures   with a counterparty after concerns were identified.
at just four of their counterparties. The Enterprises           Contingency plans also can help prepare the Enterprises for
estimate their remaining risk exposure to high-risk             unexpected collapses of counterparties that handle a
seller/servicers to be approximately $7.2 billion, based        concentrated, high-volume of their business. As of September
on these counterparties’ mortgage portfolios totaling           2011, 70% (or $3.1 trillion) of the Enterprises’ mortgage
$955 billion.                                                   portfolios were controlled by their top 10 single-family
The Federal Housing Finance Agency (FHFA or Agency),            mortgage servicers. Although these counterparties may not be
Office of Inspector General (FHFA-OIG) undertook this           on watch lists, their high concentration of the Enterprises’
audit to assess how the Agency oversees the Enterprises’        business significantly increases the financial and operational
controls over their high-risk counterparties.                   consequences of their failure. Accordingly, the Enterprises can
                                                                benefit from published FHFA guidance about when
What FHFA-OIG Found                                             counterparties’ volume and concentration of business raise their
FHFA can strengthen the Enterprises’ counterparty risk          risk enough to warrant contingency plans.
management by, among other things, publishing
standards for the development of contingency plans              What FHFA-OIG Recommends
related to failing or failed high-risk counterparties (i.e.,    In general, FHFA-OIG recommends that FHFA issue standards
step-by-step procedures explaining how to work                  for the Enterprises to develop comprehensive contingency
through a large seller/servicer’s failure). FHFA is             plans for high-risk and high-volume seller/servicers, and that
required to help the Enterprises manage risk, including         the Agency finalize its examination guidance regarding
establishing prudential limits that restrict counterparty       contingency planning.
risk exposure. Contingency plans help to manage such            The Agency’s management provided comments agreeing with
risks because they identify actions to pursue when a            the recommendations in this report.
counterparty’s changing financial or other circumstances
pose a financial threat to an Enterprise.




 Audit Report: AUD-2012-007                                                                            September 18, 2012
TABLE OF CONTENTS
TABLE OF CONTENTS .................................................................................................................3
ABBREVIATIONS .........................................................................................................................4
PREFACE ........................................................................................................................................5
BACKGROUND .............................................................................................................................6
      Selling and Servicing Loans for the Enterprises...................................................................... 6
      Enterprises’ Counterparty Risks .............................................................................................. 6
      Enterprises’ Controls over Counterparty Risks ....................................................................... 8
      Fannie Mae’s and Freddie Mac’s High-Risk Counterparty Watch Lists ................................ 8
             Freddie Mac’s Watch List .................................................................................................9
             Fannie Mae’s Watch Lists .................................................................................................9
      Contingency Plan Overview .................................................................................................. 10
      Enterprise Losses from Counterparty Failures ...................................................................... 12
      FHFA’s Oversight of Enterprises’ Counterparty Risk .......................................................... 14
FINDING .......................................................................................................................................16
CONCLUSION ..............................................................................................................................20
RECOMMENDATIONS ...............................................................................................................20
OBJECTIVE, SCOPE, AND METHODOLOGY .........................................................................21
APPENDIX A: ...............................................................................................................................23
      FHFA’s Comments on the Finding and Recommendations .................................................. 23
APPENDIX B: ...............................................................................................................................25
      FHFA-OIG’s Response to FHFA’s Comments ..................................................................... 25
APPENDIX C: ...............................................................................................................................26
      Summary of Management’s Comments on the Recommendations ....................................... 26
ADDITIONAL INFORMATION AND COPIES .........................................................................27




         Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                                       3
ABBREVIATIONS
Fannie Mae......................................................................... Federal National Mortgage Association

FHFA or Agency.......................................................................... Federal Housing Finance Agency

FHFA-OIG ..................................... Federal Housing Finance Agency, Office of Inspector General

Freddie Mac .................................................................. Federal Home Loan Mortgage Corporation

HERA.......................................................................Housing and Economic Recovery Act of 2008

MBS ..................................................................................................... Mortgage-Backed Securities

TBW ............................................................................... Taylor, Bean & Whitaker Mortgage Corp.




         Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                                 4
                                    Federal Housing Finance Agency
                                      Office of Inspector General
                                            Washington, DC



                                             PREFACE
In accordance with the Housing and Economic Recovery Act of 2008 (HERA), which amended
the Inspector General Act of 1978, FHFA-OIG is authorized to conduct audits, evaluations,
investigations, and other law enforcement activities pertaining to FHFA’s programs and
operations.1 FHFA-OIG is also authorized to recommend policies that promote economy and
efficiency, and to prevent and detect fraud and abuse.

This audit report is in furtherance of FHFA-OIG’s mission to promote the economy, efficiency,
and effectiveness of FHFA’s programs and operations, and, in accordance with FHFA-OIG’s
first strategic goal, it adds value by helping the Agency improve the Enterprises’ economic
health. Specifically, the report is intended to strengthen FHFA’s oversight of how the
Enterprises protect themselves from high-risk and high-volume counterparties that sell and/or
service mortgage loans. Doing business with such counterparties increases the Enterprises’ risk
of financial loss, which in turn can lead to their need to draw more taxpayer support from the
U.S. Department of the Treasury.2 This report identifies ways that FHFA can protect the
taxpayers’ investment better by helping the Enterprises manage their risks better.

FHFA-OIG appreciates the cooperation of everyone who contributed to the audit, including
officials at Fannie Mae, Freddie Mac, and FHFA. This audit was led by Heath Wolfe, Assistant
Inspector General for Audits, who was assisted by Andrew W. Smith, Auditor-in-Charge.




Russell A. Rau
Deputy Inspector General for Audits

1
    HERA: Public Law No. 110-289; Inspector General Act of 1978: Public Law No. 95-452.
2
 Several other FHFA-OIG audits and evaluations also demonstrate the benefit of FHFA proactively supervising the
Enterprises’ risk management. These include FHFA-OIG’s separate assessments of the Agency’s oversight of
Enterprise activities related to loan repurchase settlements, mortgage servicing contractors, and single-family
underwriting standards. See FHFA-OIG, Evaluation of the Federal Housing Finance Agency’s Oversight of
Freddie Mac’s Repurchase Settlement with Bank of America (EVL-2011-006; September 27, 2011); FHFA-OIG,
FHFA’s Supervision of Freddie Mac’s Controls over Mortgage Servicing Contractors (AUD-2012-001; March 7,
2012); and FHFA-OIG, FHFA’s Oversight of Fannie Mae’s Single-Family Underwriting Standards (AUD-2012-
003; March 22, 2012).


         Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                       5
BACKGROUND
The Enterprises support the secondary mortgage market by purchasing residential mortgage
loans from lenders. They may hold these mortgages as their own investments or bundle them
into mortgage-backed securities (MBS)—typically with guarantees covering principal and
interest payments—for sale to other investors. MBS issued or guaranteed by government
agencies (e.g., the Government National Mortgage Association) or government-sponsored
enterprises, such as the Enterprises, are referred to as “agency MBS.” In 2011, the agency MBS
market of $5.5 trillion was more than four times larger than the non-agency MBS market.

Selling and Servicing Loans for the Enterprises
The Enterprises’ mortgage-related business is considerable. The Enterprises owned or
guaranteed $4.6 trillion of the nation’s estimated $10.3 trillion in outstanding single-family
mortgages as of September 30, 2011. In other words, the Enterprises own or guarantee almost
half of all mortgages on homes in the United States.

The same lenders that sell these mortgages to the Enterprises frequently also service the loans for
them. Servicing includes much of the day-to-day work involved with mortgages, such as:
        Collecting payments from borrowers;
        Maintaining escrow accounts for property taxes and insurance; and
        Handling mortgage modifications, defaults, and foreclosures.

In 2011, the Enterprises worked with over 2,000 servicers.

Doing such a large volume of business with multiple counterparties poses risks to the Enterprises
when their success depends on the counterparties’ stability.3 Indeed, as demonstrated by the
recent housing crisis, counterparties can fail rapidly in response to adverse market conditions.

Enterprises’ Counterparty Risks
Since 2007, the Enterprises have suspended or terminated business with more than
40 seller/servicers on their high-risk watch lists. Although such suspensions and terminations are
designed to protect the Enterprises from one or more specific risks and to stop the creation of
additional exposure, they can leave them vulnerable to a variety of other financial risks,
including:

3
  For the purposes of this report, “counterparty” refers to an entity that sells mortgages to and/or services mortgages
for the Enterprises. In general, the term “counterparty” can also refer to other entities that have contractual relations
with the Enterprises, such as mortgage insurance companies, asset managers, real estate brokers, etc.


        Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                            6
         Loss of guarantees on counterparties’ work. Counterparties commit (i.e., they make
          representations and warranties when they sell loans to the Enterprises) to follow
          Enterprise requirements for underwriting mortgage loans. If they do not comply, the
          Enterprises can have them repurchase the loan(s) they sold to the Enterprises for up to
          full face value or terminate their servicing rights. However, if a counterparty sold the
          Enterprises mortgage loans that did not meet standards (e.g., borrowers lack the
          necessary income to pay their mortgages), the Enterprises could lose the full or partial
          loan amounts if borrowers default following the counterparty’s failure.
         Increased tax and insurance payments. If a servicer fails and its portfolio cannot be
          transferred quickly, an Enterprise may have delayed access to the tax and insurance
          escrow accounts, potentially resulting in late fees for not making timely payments for the
          underlying properties’ insurance and tax obligations as the servicer normally would have
          done.
         Legal fees and associated costs.
               o Counterparty bankruptcy cases can be complex and take years to complete. The
                 Enterprises need specialized legal representation to make, negotiate, and settle
                 claims in competition with other entities seeking to recover funds from the
                 counterparty (e.g., mortgage payments and escrow accounts held at the time of the
                 failure/bankruptcy filing).
               o In addition, there is risk inherent in moving mortgages to other servicers,
                 including expenses incident to the transfer of servicing responsibilities from the
                 failed servicer (e.g., costs associated with the physical movement of loan files
                 from one servicer to another).

The volume of business an Enterprise does with a given counterparty can magnify such risks.
Due to consolidation in the mortgage industry and mortgage lenders that went out of business
during the housing crisis, the Enterprises’ loan purchasing business has concentrated among
fewer large mortgage lenders.4 For example, as of September 2011, the Enterprises’ top
10 seller/servicers were responsible for 70% of their mortgage portfolios.

In their recent financial filings, the Enterprises acknowledged that they face significant risks
from the sudden collapse of large counterparties. Freddie Mac noted that it would have
“operational and capacity challenges . . . transferring a large servicing portfolio” to a new
servicer in the event one or more of its largest seller/servicers collapsed.5 Similarly, Fannie Mae
warned that “failure by a significant seller/servicer counterparty, or a number of seller/servicers,

4
    Federal National Mortgage Association SEC 10K for FY 2011, p.52.
5
    Federal Home Loan Mortgage Corporation SEC 10K for FY 2011, p. 133.


          Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                        7
to fulfill repurchase obligations to us could result in a significant increase in our credit losses and
have a material adverse effect on our results of operations and financial condition.”6

To address such risks, the Enterprises screen counterparties before working with them, require
them to guarantee that they will follow rules for selling/servicing mortgage loans, and monitor
their ongoing performance, financial condition, and compliance.

Enterprises’ Controls over Counterparty Risks
Before agreeing to do business with seller/servicers, the Enterprises assess their financial
strength and operational capabilities, and ensure they meet eligibility requirements. For
example, the Enterprises may take precautionary steps such as requiring seller/servicers to meet
minimum financial capacity standards. They also conduct operational reviews of their single-
family mortgage seller/servicers and use this information to determine the terms of their business
with them (e.g., setting limits on financial transactions).

In addition, both Enterprises have guides that outline counterparties’ responsibilities.7 For
example, the Enterprises require sellers to ensure that the mortgages they originate comply with
underwriting requirements, which set standards for borrowers’ eligibility (e.g., credit score
thresholds) and collateral sufficiency. Counterparties represent and warrant their compliance
with these Enterprise guidelines. If the Enterprises suffer a loss on a loan and discover that the
seller significantly deviated from its representations and warranties, they can recoup their losses.

Further, although the Enterprises generally do not conduct compliance reviews on loans before
purchase, they review samples of loans after purchase to ensure adherence to Enterprise
requirements. The Enterprises also have fraud programs that review cases of suspected fraud,
identify fraud risk, and work to remediate fraud and recoup losses.

Despite such precautions, doing business with counterparties poses risks. For example, a
servicer’s financial condition may deteriorate to the point of bankruptcy if market conditions
change. The Enterprises protect themselves from such risk by establishing counterparty limits
and identifying and monitoring high-risk counterparties.

Fannie Mae’s and Freddie Mac’s High-Risk Counterparty Watch Lists
As summarized below, the Enterprises have independently developed systems to identify high-
risk counterparties and add them to watch lists to monitor their performance. In total, as of


6
    Federal National Mortgage Association SEC 10K for FY 2011, p. 66.
7
 Fannie Mae 2012 Single-Family Selling Guide; Fannie Mae Single-Family 2011 Servicing Guide; and Freddie
Mac Single-Family Seller/Servicer Guide.


         Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                        8
September 2011, the Enterprises had identified more than 300 high-risk seller/servicers with an
estimated risk exposure of $7.2 billion.

       Freddie Mac’s Watch List
       Freddie Mac’s Counterparty Credit Risk Management Group conducts a three-phase
       review to identify seller/servicers to add to the Enterprise’s watch list. The review
       procedure includes analyzing financial and operational information.
       The group reports the results of its reviews and recommends remediation plans as
       appropriate to a special committee that reviews them. These plans can include
       terminating the Enterprise’s business relations with the counterparty, increasing the
       collateral required from it, etc. After the committee determines the appropriate
       remediation plan, Freddie Mac’s watch list is updated accordingly.

       Fannie Mae’s Watch Lists
       Fannie Mae has two watch lists: (1) an Enterprise risk management list for all its high-
       risk counterparties across all of its business units including single- and multi-family
       housing, and (2) a high-risk lender list specifically for high-risk single-family
       seller/servicers.

       Fannie Mae’s Counterparty Risk Monitoring Unit can add a counterparty to the lists
       when it determines that a seller/servicer has a deficiency or the potential to breach its
       contract. For example, the unit may add a counterparty to a watch list for problems
       including financial and operational concerns.
       Next, the unit prepares a fact sheet, also known as an “Action Plan,” detailing any issues
       and recommended sanctions or remedial actions, and then sends it to Fannie Mae’s
       Counterparty Analysis and Single-Family Underwriting and Pricing teams, which may
       add information and recommendations. If a seller/servicer does not resolve the problems
       identified in the Action Plan, the Enterprise can fine it, suspend it, or terminate business
       with it.

The Enterprises take ad hoc, remedial actions in response to specific deficiencies they identify
with high-risk counterparties on their watch lists. For example, one Enterprise found that one of
its seller/servicer’s loan portfolios was underperforming. The counterparty was at risk of going
out of business and threatened to encumber Fannie Mae with costs associated with finding a new
company to take over servicing the Enterprise’s loan portfolio. Therefore, Fannie Mae took
remedial steps such as reducing the Enterprise’s credit exposure to the counterparty and
requiring additional collateral. Ultimately, the seller/servicer did not fail and continues to work
with Fannie Mae. These specific remedial actions, however, do not always prevent the
Enterprises from suffering losses from their work with high-risk counterparties.


      Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                    9
Additionally, employing ad hoc risk reduction tools to remediate specific deficiencies differs
from systemically incorporating the tools into a formalized, comprehensive plan that accounts
for various adverse economic scenarios. For example, the Enterprises have each identified a
particular large seller/servicer as high-risk on their respective watch lists; the seller/servicer
represents an estimated risk exposure of $3.5 billion and is responsible for servicing thousands of
mortgages for the Enterprises. Although the Enterprises have taken steps to protect themselves
from the immediate risks they have identified, they have not prepared a systematic plan to
respond to more disastrous potential eventualities, such as the seller/servicer’s failure to meet its
contractual obligations to the Enterprises. Alternatively, contingency planning could pre-
establish a systematic process to manage the transfer of thousands of mortgages on short notice
from one servicer to another.

Contingency Plan Overview
Generally, contingency plans are risk management mechanisms designed to guide organizations
to respond effectively if a particular event occurs or fails to occur. In the context of a
counterparty’s financial deterioration or failure, a contingency plan is a step-by-step protocol
governing how to work through the risk that the counterparty may be unable to satisfy its
contractual obligations. Contingency plans may not prevent losses in the event of a
counterparty’s failure, but they may reduce risk exposure.

In spite of the obvious advantages of contingency plans and the fact that the Agency has
identified seller/servicer failures as a high risk, FHFA has not required the Enterprises to prepare
contingency plans to avoid or mitigate the consequences of counterparty deterioration or failure.
The Enterprises should have contingency plans in place to provide provisional processes in case
of counterparty failure. Such plans should be developed based on each Enterprise’s assessment
of the risks posed by its counterparties, which could include individual plans or group plans for
counterparties based upon size or risk tier. The objective of the plans should be to restore
operations quickly and seamlessly with approved counterparties, proactively anticipating
alternative courses of action while minimizing the impact of counterparty failure.

Among other regulators, the practice of developing counterparty contingency plans is generally
considered a best practice. For example, the Interagency Supervisory Guidance on Counterparty
Credit Risk Management (June 2011) is a joint guide issued by the Office of the Comptroller of
the Currency, the Federal Deposit Insurance Corporation, the Board of Governors of the Federal
Reserve System, and the Office of Thrift Supervision. The guide is intended to help banking
organizations establish their counterparty risk management practices and includes criteria for
counterparty failure contingency plans. The guide refers to such contingency plans as “close out
plans” and recommends that at a minimum organizations should:



      Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                   10
      Develop a sequence of critical task and decision-making responsibilities needed to
       execute a counterparty close-out;
      Test a hypothetical close-out simulation for a complex counterparty at least once every
       two years;
      Develop standards for the speed and accuracy with which the organization can compile
       comprehensive counterparty exposure data and net cash outflows within four hours of the
       failure; and
      Periodically review documentation related to counterparty terminations and confirm that
       current agreements specify the definition of events of default and the termination
       methodology that will be used.

Accordingly, contingency plans should be comprehensive and include all critical processes
addressing how counterparty risk will be managed and operations continued if a counterparty
fails. Beyond these basic requirements, a plan should include quantitative assessment, event
management, monitoring, and testing, as follows:
      Contingency plans should quantify the impact a counterparty failure is expected to have
       on the Enterprise. The plan can identify events that would have a significant effect on the
       Enterprise, assess the level and nature of impact on the Enterprise, and identify
       alternative, qualified counterparties that may be used during the contingency period. As
       part of the plan, the Enterprise would have to assess its other counterparties’ ability to
       accept that new business, especially if it were a large volume of activity.
      Contingency plans should also include an event management process outlining
       procedures during the contingency period. Contingency actions may include curtailing
       existing or new activities with the failed counterparty or transferring that business to
       other qualified counterparties. The contingency plan also should discuss circumstances
       that will trigger action (including, but not limited to, rating downgrades), limits on the
       potential future exposure, and the impact of collateral requirements. Further,
       management information systems should be able to supply quick and accurate
       information on exposures to support the plan. In addition, the contingency plan should
       identify authorized individuals and their responsibilities for executing the procedures.
      The contingency plan should include a monitoring component so the Enterprise is ready
       for a potential counterparty failure. Monitoring emerging events and other risks related
       to the Enterprise’s counterparties not only positions the Enterprise to work proactively to
       minimize its counterparty exposure, but such information also enables the Enterprise to
       update its contingency plan(s) as appropriate based on new or changing market
       conditions.



       Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                    11
        Plans should be tested periodically. Testing allows the Enterprise to assess the
         contingency plan’s reliability during the contingency period. Such testing would include
         mimicking a crisis to test communications, coordination, and decision-making. In
         addition, the Enterprise should periodically evaluate whether other qualified
         counterparties could accept new business from a failed counterparty, especially if it were
         a large volume of activity.

Enterprise Losses from Counterparty Failures
Despite steps to identify, monitor, and mitigate the impact of potential failures of high-risk
counterparties, the Enterprises have suffered significant losses and/or have accumulated
significant future exposure from seller/servicers on their watch lists. In some cases, these
counterparty failures were due to fraud and in others were due to risky business models. For
example, Fannie Mae estimates losses and future exposure resulting from the failure of three
selected counterparties to be approximately $4.35 billion.8

Freddie Mac’s interaction with one seller/servicer, Taylor, Bean & Whitaker Mortgage Corp.
(TBW), illustrates the risks associated with the failure of a high-risk or high-volume
counterparty. FHFA’s review of Freddie Mac’s business with TBW found that TBW was
undercapitalized, underperforming, and carried too much debt.9 The Enterprise placed the
counterparty on its high-risk watch list in December 2007.10 Nonetheless, as shown in Figure 1
below, Freddie Mac increased its volume of business with TBW from over $43 billion to
approximately $52 billion at the end of 2008 and its corresponding risk exposure increased from
almost $64 million to about $244 million at the end of 2008.11 In August 2009, when the Federal
Bureau of Investigation executed a search warrant at TBW’s headquarters as part of a criminal
fraud investigation, total business volume stood at approximately $49 billion and total exposure
was around $702 million.

8
  The figure does not cover all of Fannie Mae’s losses from all high-risk seller/servicers, but instead reflects
information that was readily available from the Enterprise.
9
 “Undercapitalized” is used generally to refer to a counterparty’s insufficient self-funding or equity to support its
operations.
10
   TBW had worked with both Enterprises, but, in January 2000, a Fannie Mae executive discovered that TBW had
sold the same loans to more than one entity including Fannie Mae. In April 2002, Fannie Mae ended its relationship
with TBW due to possible fraud, but it did not report the termination to law enforcement or outside the Enterprise.
FHFA’s predecessor agency, the Office of Federal Housing Enterprise Oversight, was aware of the termination, but
not its basis. Accordingly, Freddie Mac continued to conduct business with TBW without intervention. See
additional information in FHFA-OIG, Audit of the Federal Housing Finance Agency’s Consumer Complaints
Process (AUD-2011-001, June 21, 2011).
11
   Risk exposure is influenced by a number of factors, only one of which is volume (servicing portfolio). The 2007-
2008 housing crisis caused a steep drop in home prices and increased losses on defaulted mortgages, which resulted
in a more dramatic increase in Freddie Mac’s risk exposure.


         Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                           12
     Figure 1: Freddie Mac’s Rising Volume of Business and Risk Exposure with TBW12
                                     (Year-End Data)
                         $800                                                               $60,000
                         $700          TBW added to watch
                                                                                            $50,000
                                       list
                         $600




                                                                                                       Volume of Business
        Total Exposure




                                                                                            $40,000
                         $500
                         $400                                                               $30,000
                         $300
                                                                                            $20,000
                         $200
                                                                                            $10,000
                         $100
                          $-                                                                $-
                                2004   2005       2006      2007     2008        2009   Dollar amounts in
                                         Total Exposure       Volume of Business        millions


        Source: FHFA-OIG’s analysis of Freddie Mac’s Data.

In July 2009, Freddie Mac required TBW to post collateral, a measure that could mitigate losses
from a counterparty that poses risk. However, TBW collapsed shortly thereafter. On August 4,
2009, TBW’s business with Freddie Mac was terminated and, in June 2010, Freddie Mac filed a
claim for $1.8 billion in TBW’s bankruptcy proceeding.13

Contingency planning may have reduced Freddie Mac’s losses. For example, Freddie Mac could
have implemented a contingency plan that outlined procedures to monitor and curtail TBW’s
existing or new activities when it learned that TBW’s financial condition was deteriorating. As
discussed below, FHFA recognizes that contingency planning can reduce the Enterprises’
counterparty risk exposure (i.e., the Agency recently asked the Enterprises for contingency plans
as part of its supervisory process, see below at p. 19), but FHFA has not published written policy
guidance for the Enterprises requiring such contingency plans or describing what should be
included in them.




12
  The decreased servicing portfolio for 2009 represents a partial year of purchases due to Freddie Mac suspending
business with TBW, but the Enterprise estimated its rising risk exposure through the end of the year based on its
projection of repurchases.
13
   According to publicly available information, Freddie Mac filed a claim in the amount of approximately
$1.8 billion on or about June 14, 2010. For additional information, see p. 4 of 9 at
http://www.scribd.com/doc/58862183/Docket-3237-TBW-Freddie-Mac-Settlement-Agreement, accessed on
August 22, 2012.


       Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                          13
FHFA’s Oversight of Enterprises’ Counterparty Risk
Under HERA, FHFA is responsible for establishing standards for systems to identify
concentrated financial risk and to set limits on the Enterprises’ risk exposure.14

In part, FHFA fulfills these responsibilities by providing guidance for its Division of Enterprise
Regulation to examine, among other things, the Enterprises’ contingency plans for
counterparties.15 FHFA’s 2009 supervision manual directed its examiners to consider the
Enterprises’ use of contingency plans to mitigate counterparty risks and to protect acquisition
activities (e.g., buying mortgages).16 FHFA’s Division of Supervision Policy and Support
(previously the Division of Examination Programs & Support) further developed Agency
examination procedures in a February 2012 draft examination manual, which is currently being
field tested.17 The new draft manual provides guidance for Agency examiners to review the
Enterprises’ contingency plans for detailed risk management procedures to reduce risks in the
event of a seller/servicer’s collapse.

According to FHFA’s draft examination manual, it is a prudent practice to develop plans for
reducing counterparty risk that is viewed as being too high (e.g., when the counterparty’s credit
rating drops below a predetermined threshold). FHFA also believes that contingency plans
should be risk-based and provide a variety of actions to consider relative to adverse changes in a
counterparty’s financial condition. For instance, a contingency plan can describe what actions
will be taken to reduce exposure to a counterparty’s deteriorating financial condition (e.g.,
transferring assets to other counterparties or specifying a timeline to reduce exposure). FHFA’s
draft manual prescribes that contingency plans should correspond to weaknesses disclosed by
stress testing counterparties.18 The manual also states that contingency plans should include
increasing supervision, limiting further advances (i.e., loans), restricting portfolio growth, and
devising exit strategies. FHFA’s Examiner-in-Charge for Fannie Mae described a contingency



14
     12 U.S.C. § 4513b(9).
15
   The contingency plans discussed here differ from the “resolution plans” required by the Dodd-Frank Wall Street
Reform and Consumer Protection Act. According to the Act, financial institutions, including insured depository
institutions with assets over $50 billion, are required to have resolution plans for winding down if they fail or go
bankrupt. Also, the resolution plans are designed to protect creditors and depositors from collapses by regulated
financial entities. In contrast, contingency plans as defined by FHFA in its Draft Examination Manual, Credit Risk
Management (February 2012) focus on protecting the Enterprises from the financial deterioration of their
counterparties.
16
     FHFA Division of Enterprise Regulation, Supervision Reference and Procedure Manual (June 2009), p. 9.
17
     FHFA, Draft Examination Manual, Credit Risk Management (February 2012).
18
   Stress testing is a risk management tool through which an organization analyzes various adverse financial,
structural, or economic scenarios to determine how they would affect the business.


          Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                         14
plan’s goal: “[it] should identify the credit and operational risks stemming from a seller/servicer
failure, and establish responsibility and procedures to contain and mitigate risks.”

Although FHFA recognizes the importance of contingency planning as part of a strategy to
identify and mitigate counterparty risk exposure, the Agency has not published written policies
requiring the Enterprises to develop and maintain such plans or explaining what should be in
them. As discussed in the finding that follows, FHFA-OIG encourages the Agency to fully
realize the benefits to be derived from contingency planning by promptly publishing guidance
requiring the Enterprises to develop and maintain plans for FHFA’s review under its examination
policies.




      Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                   15
FINDING
FHFA Can Better Supervise the Enterprises’ Risk Management of High-Risk
Counterparties by Issuing Standards for Contingency Plans

FHFA can help strengthen the Enterprises’ risk management by establishing standards for
developing contingency plans for dealing with high-risk and high-volume counterparties. (Such
plans could be individual or grouped according to counterparty size or risk tier.) In the absence
of such guidance, the Enterprises have not developed contingency plans for the more than 300
counterparties on their high-risk watch lists, nor have they developed contingency plans for their
largest seller/servicers.19

HERA requires that FHFA establish standards for each regulated entity to manage credit and
counterparty risk.20 These standards include systems to identify concentrated financial risk and
to set prudential limits restricting the Enterprises’ risk exposure. FHFA has taken some positive
steps toward meeting this requirement by providing guidance for its examiners to review
contingency plans.

However, although FHFA asked for contingency plans as part of its supervisory process (see
below at p. 19), the Agency has not published written policy guidance for the Enterprises
requiring contingency plans or governing what should be included in them. Instead, FHFA has
been field testing draft examination procedures, hoping that the Enterprises will voluntarily
conform their procedures to the Agency’s internal examination instructions.

Consequently, the Enterprises have not developed contingency plans. Documents provided by
the Enterprises in response to FHFA-OIG requests for contingency plans illustrate how the
Enterprises have not met the standards outlined in the Interagency Supervisory Guidance on
Counterparty Credit Risk Management.
              Fannie Mae initially advised that its “Action Plans” for high-risk seller/servicers are
               contingency plans. FHFA-OIG notes that, although these action plans list remedial
               actions taken by Fannie Mae or the counterparty in response to specific deficiencies,
               they do not lay out in advance comprehensive procedures for reducing the
               Enterprise’s risk exposure relative to the counterparty’s financial condition or other
               deficiencies that fail to improve. In response to another FHFA-OIG request for
               contingency plans, Fannie Mae conceded that its management has informally
               discussed contingency planning but does not formally establish contingency plans.

19
     As stated above, the Enterprises’ top 10 servicers are responsible for 70% of their mortgage portfolios.
20
     12 U.S.C. § 4513b(9).


          Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                            16
             In response to FHFA-OIG’s request for contingency plans, Freddie Mac provided
              various documents related to screening counterparties (e.g., credit applications),
              monitoring them (e.g., financial reviews), and remediating specific risks (e.g.,
              requiring more collateral). Although these actions may help mitigate Freddie Mac’s
              counterparty risk, the Enterprise’s tools and actions do not constitute an overall
              contingency plan as outlined by the Interagency Supervisory Guidance on
              Counterparty Credit Risk Management because they do not lay out a comprehensive
              plan of action to limit risk exposure in case of deteriorating financial conditions or
              failure.21

             In March 2012, Fannie Mae’s Agency Examiner-in-Charge agreed with FHFA-OIG’s
              conclusion that “Fannie Mae does not have a contingency plan to manage the risk of a
              failed seller/servicer institution.” The same was true for a Freddie Mac examiner who
              told FHFA-OIG that “Freddie [Mac] does not have a document that lays out their plan
              in a comprehensive manner.”

As indicated by these examples, the Enterprises’ processes to manage their exposure to
seller/servicers they have identified as high risk do not yield contingency plans that prescribe
procedures to follow (e.g., an exit strategy) in response to potential risks (e.g., bankruptcy or
termination). Figure 2 on the next page illustrates how a more comprehensive counterparty risk
management process with prescribed future actions could further FHFA’s goal of preserving and
conserving the Enterprises’ assets. The red boxes represent where FHFA contingency plan
standards could help limit the Enterprises’ financial exposure to high-risk counterparties.




21
     FHFA, Draft Examination Manual, Credit Risk Management (February 2012).


         Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                      17
              Figure 2: The Enterprises’ Counterparty Risk Management Process

                                                                                                     Legend

                                          The Enterprises enter into contract
                                                                                                         Summary of current
                                          negotiations with the seller/servicer
                                                                                                         process

                                                                                                         Areas of potential
                                                                                                         improvement


    Defines the terms of the agreement,
    e.g.:                                            Seller/servicer
     How service is performed                          contract
     Volume of loans to be serviced
     Grounds for termination


                                        The Enterprises’ business units and
                                       risk management groups monitor the
                                           seller/servicer’s performance.

                                                                                   A seller/servicer may be considered
                                                                                   high-risk and added to the Enterprises’
                                                       Watch List                  watch lists because of issues, such as:
                                       No              Processes                    Cash flow problems
                                                       Triggered                    High repurchase rates
                                                                                    Operational issues
                                                                                    Breach of contract terms

                                                           Yes

                                                                                     The Enterprises had no contingency
                                                                                     plans for the counterparties identified as
                                                                                     high risk. The Enterprises’ contingency
                                                      Enterprises
                                                                                     plans should include:
                                                       Develop
                                                                                      Quantitative assessment
                                                   Contingency Plans
                                                                                      Event management
                                                                                      Monitoring
                                                                                      Testing

A seller/servicer may be affected by
adverse events, such, as:
 Bankruptcy                                         Adverse Event            No
 Termination
 Financial deterioration

                                                           Yes



                                                Enterprises Implement
                                                  Contingency Plans




               Source: FHFA-OIG analysis of Enterprise counterparty risk management procedures.




      Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                                    18
As a result of FHFA-OIG’s audit, FHFA’s Examiners-in-Charge asked the Enterprises to
develop servicer contingency failure plans as part of the Agency’s supervisory process. With
respect to Fannie Mae, the Agency examiner also asked that the plan be a written document that
the Enterprise can reference, execute, test, and account for in the event of a servicer’s sudden and
unexpected failure. This request is noteworthy; but, the Agency has not published written policy
guidance for the Enterprises regarding what should be included in such contingency plans or
formally requiring their creation. FHFA should follow through by issuing contingency plan
standards that require both Enterprises to develop plans for both high-risk and concentrated,
high-volume counterparties as defined by the Agency.




      Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                   19
CONCLUSION
As of September 2011, high-risk counterparties managed mortgage portfolios of $955 billion and
exposed the Enterprises to an estimated $7.2 billion in potential financial losses. In addition, the
Enterprises’ 10 largest servicers were responsible for handling $3.1 trillion in outstanding
mortgages. As shown by the more than 40 seller/servicers that the Enterprises have suspended or
terminated since 2007, and by the Enterprises’ estimates of up to $6.1 billion in losses following
the failure of just 4 high-risk seller/servicers, the Enterprises face significant risks from their
counterparties.




RECOMMENDATIONS
FHFA-OIG recommends that FHFA:
   1. Issue standards, by regulation or guidelines, for the Enterprises to develop comprehensive
      contingency plans for their high-risk and high-volume seller/servicers (individually or by
      group). At a minimum, these standards should include quantitative assessment, event
      management (e.g. curtailing business with or transferring business from a seller/servicer
      or specifying reasonable timeframes for reducing risks), monitoring, and testing
      elements.
   2. Finalize FHFA’s February 2012 draft examination manual to include elements related to
      contingency planning.




      Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                   20
OBJECTIVE, SCOPE, AND METHODOLOGY
This performance audit’s objective was to assess FHFA’s oversight of the Enterprises’
management of counterparty risk related to high-risk seller/servicers. Although FHFA-OIG
focused on FHFA’s supervision of the Enterprises, FHFA-OIG also performed a limited review
of the Enterprises’ management of high-risk counterparties.

The audit scope was from August 1, 2009, through September 30, 2011, and was expanded as
necessary. FHFA-OIG performed field work from October 2011 through April 2012 at FHFA’s
offices in Washington, DC; Fannie Mae’s headquarters in Washington, DC; and Freddie Mac’s
headquarters in McLean, VA.

To achieve its objective, FHFA-OIG:
      Interviewed FHFA and Enterprise officials about their oversight of high-risk
       counterparties;
      Assessed FHFA’s 2009, 2010, and 2011 quarterly risk assessment processes for
       counterparty risk;
      Reviewed FHFA’s 2008, 2009, and 2010 examination reports on the Enterprises,
       focusing on counterparty risk;
      Evaluated the Enterprises’ 2009 and 2012 policies and procedures for managing high-risk
       counterparties; and
      Sampled the Enterprises’ respective high-risk counterparty watch lists (2007–2012) to
       review their procedures for monitoring, reporting, and mitigating risk exposure.

FHFA-OIG also 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 used to meet its mission, goals, and objectives, and include the processes and
procedures for planning, organizing, directing, and controlling program operations as well as the
systems for measuring, reporting, and monitoring program performance. Based on the work
completed in this performance audit, FHFA-OIG considers weaknesses in FHFA’s oversight of
the Enterprises’ management of counterparty risk related to high-risk seller/servicers to be
significant in the context of the audit’s objective.

FHFA-OIG conducted this performance audit 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

       Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                    21
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.




      Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                   22
APPENDIX A:
FHFA’s Comments on the Finding and Recommendations




    Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                 23
Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                             24
APPENDIX B:
FHFA-OIG’s Response to FHFA’s Comments
On August 27, 2012, FHFA provided comments to a draft of this report agreeing with both
recommendations and identifying FHFA actions to address them. FHFA-OIG considers the
actions sufficient to resolve the recommendations, which will remain open until FHFA-OIG
determines that agreed-upon corrective actions are completed and responsive to the
recommendations. 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 recommendations and the status of agreed-to corrective actions.




      Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                   25
APPENDIX C:
Summary of Management’s Comments on the Recommendations
This table presents the management response to the recommendations in FHFA-OIG’s report and
the status of the recommendations as of when the report was issued.

                                                         Expected
      Rec.        Corrective Action: Taken or           Completion      Monetary       Resolved:       Open or
      No.                    Planned                       Date         Benefits       Yes or Noa      Closedb
       1.     Issue standards, by regulation or          3/31/2013        $0              Yes           Open
              guidelines, for the Enterprises to
              develop comprehensive contingency
              plans for their high-risk or high-
              volume seller/servicers (individually
              or by group). At a minimum, these
              standards should include
              quantitative assessment, event
              management (e.g. curtailing
              business with or transferring
              business from a seller/servicer or
              specifying reasonable timeframes
              for reducing risks), monitoring, and
              testing elements.
       2.     Finalize FHFA’s February 2012                3/31/2013         $0            Yes           Open
              draft examination manual to include
              elements related to contingency
              planning.
     Total                                                                   $0


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 agreed-upon corrective actions have been completed and are responsive, the
recommendations can be closed.




       Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                      26
ADDITIONAL INFORMATION AND COPIES


For additional copies of this report:

       Call the Office of Inspector General: 202-730-0880

       Fax your request: 202-318-0239

       Visit FHFA-OIG’s website: 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: 1-800-793-7724

       Fax your written complaint: 202-318-0358

       Email us: oighotline@fhfaoig.gov

       Write us: FHFA Office of Inspector General
                 Attn: Office of Investigation – Hotline
                 400 Seventh Street, S.W.
                 Washington, DC 20024




      Federal Housing Finance Agency Office of Inspector General • AUD-2012-007 • September 18, 2012
                                                   27