oversight

FHFA's Oversight of the Asset Quality of Multifamily Housing Loans Financed by Fannie Mae and Freddie Mac

Published by the Federal Housing Finance Agency, Office of Inspector General on 2013-02-21.

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

         FEDERAL HOUSING FINANCE AGENCY
           OFFICE OF INSPECTOR GENERAL

         FEDERAL HOUSING FINANCE AGENCY
           OFFICE FHFA’s
                  OF INSPECTOR
                         OversightGENERAL
                                  of
       the Asset Quality of Multifamily Housing Loans
          Financed by Fannie Mae and Freddie Mac




AUDIT REPORT: AUD-2013-004                     February 21, 2013


EVALUATION REPORT: EVAL-2012-XX           DATED: Month XX, 2012
                                                 AT A GLANCE
      FHFA’s Oversight of the Asset Quality title
                                            of Multifamily Housing Loans Financed by
                               Fannie Mae and Freddie Mac
                                                                     have been adequately representative. However, the examiners
Why OIG Did This Audit
The housing crisis has led to increased demand for rental
                                                                titledid not retain sufficient documentation to permit OIG to assess
                                                                title
                                                                     fully their sampling methodology.
housing. Since 2006, the nation has lost 1.9 million
homeowners and has added 4.9 million renters. However,               On the other hand, the agency’s Freddie Mac examiners
as the housing crisis intensified in 2008, private sector            reviewed a more limited sample of 17 loans. When compiling
financing for multifamily loans (e.g., loans to buy apartment        their sample, the examiners excluded from their sample
buildings) largely vanished.                                         universe 829 multifamily loans valued at approximately
                                                                     $11.5 billion. Some of the excluded loans may have
Fannie Mae and Freddie Mac (the Enterprises) stepped into            represented a higher risk because they were subject to relaxed
the financing gap by continuing to provide a steady source of        underwriting standards. Further, in all but one case, the face
financing in the secondary mortgage market for multifamily           amounts of the loans in the sample were less than the average
loans. In 2009, for example, the Enterprises bought 85% of           Freddie Mac multifamily loan of $13 million. As a result of the
the nation’s multifamily loans, and they continued their             sampling differences, the Freddie Mac sample may not have
dominant presence in the market through 2011 when they               been sufficiently representative and potentially did not give the
bought nearly 57% of the multifamily loans, valued at                agency reasonable assurance of asset quality—one of the
$44 billion.                                                         examination’s objectives.
FHFA (the agency) uses onsite safety and soundness                   OIG attributes the difference between the sampling techniques
examinations as its primary oversight tool to assess the             used by FHFA’s two examination teams to the absence of
Enterprises’ financial condition, performance, and                   FHFA policies or procedures articulating how to select samples
operations. Given the size of the Enterprises’ investment            for review during targeted examinations. In contrast, industry
and their dominant role in the secondary market for                  peers—as well as FHFA’s Federal Home Loan Bank
multifamily loans, OIG performed this audit to assess                examiners—have adopted sampling guidance that requires
FHFA’s supervisory oversight of the Enterprises’ controls            implementation of representative or proportional sampling
over multifamily loan underwriting.                                  methods to select adequate samples from loan populations.
What OIG Found                                                       What OIG Recommends
OIG found that the agency can improve its examination                FHFA can increase its confidence in the efficacy of loan reviews
policies in the area of sample selection. For instance, FHFA         during targeted examinations by providing its examiners with
recently conducted, at each Enterprise, a multifamily asset          clear guidance about how to select samples, and by requiring
quality examination that included a review of the                    them to maintain documentation adequate to support their
Enterprises’ compliance with their underwriting standards.           sampling methodology.
OIG noted that the examinations had the same scope and
objective, but FHFA examiners selected loans differently             FHFA provided comments agreeing with the recommendations
during their review of each Enterprise. The agency’s Fannie          in this report.
Mae examiners chose for review a sample of 30 loans across
major risk categories and dollar values. That sample may



Audit Report: AUD-2013-004                                                                                    February 21, 2013
TABLE OF CONTENTS
TABLE OF CONTENTS ................................................................................................................ 3
ABBREVIATIONS ........................................................................................................................ 4
PREFACE ....................................................................................................................................... 5
BACKGROUND ............................................................................................................................ 6
      Enterprises’ Role in Primary and Secondary Residential Mortgage Markets ......................... 6
      Multifamily Housing Loan Market .......................................................................................... 7
      Enterprises’ Presence in the Multifamily Loan Market ........................................................... 7
      Enterprises’ Relaxed Multifamily Underwriting Standards .................................................... 9
      FHFA’s Supervision of the Enterprises’ Multifamily Businesses ......................................... 11
             FHFA’s Oversight Responsibilities ................................................................................ 11
             FHFA’s Multifamily Risk Assessment and Examination Planning for the
               Enterprises ................................................................................................................. 11
             FHFA’s Supervision Planning and Supervisory Activities ............................................ 12
      FHFA’s Multifamily Asset Quality Examinations ................................................................ 13
             Results of the Asset Quality Examinations .................................................................... 13
             Sampling Methodology for the Asset Quality Examinations ......................................... 13
FINDING ...................................................................................................................................... 16
CONCLUSION ............................................................................................................................. 18
RECOMMENDATIONS .............................................................................................................. 19
SCOPE AND METHODOLOGY ................................................................................................ 20
APPENDIX A: FHFA’S COMMENTS ON FINDING AND RECOMMENDATIONS ........... 22
APPENDIX B: OIG’S RESPONSE TO FHFA’S COMMENTS................................................ 24
APPENDIX C: SUMMARY OF MANAGEMENT’S COMMENTS ON THE
RECOMMENDATIONS .............................................................................................................. 25
ADDITIONAL INFORMATION AND COPIES ........................................................................ 26




           Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
                                                          3
ABBREVIATIONS
Enterprises.......................................................................................... Fannie Mae and Freddie Mac
Fannie Mae......................................................................... Federal National Mortgage Association
FDIC ................................................................................... Federal Deposit Insurance Corporation
FHFA ........................................................................................... Federal Housing Finance Agency
Freddie Mac .................................................................. Federal Home Loan Mortgage Corporation
HERA.......................................................................Housing and Economic Recovery Act of 2008
OCC ............................................................................... Office of the Comptroller of the Currency
OIG ................................................. Federal Housing Finance Agency Office of Inspector General
MBS ..................................................................................................... Mortgage-Backed Securities




          Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
                                                         4
                                  Federal Housing Finance Agency
                                    Office of Inspector General
                                          Washington, DC



                                           PREFACE
A series of reports by OIG has assessed FHFA’s examinations of the Enterprises and its
oversight of their underwriting standards. For example, OIG has found that FHFA can strengthen
its oversight of Fannie Mae’s underwriting standards for single-family housing.1 Also, OIG has
recommended that FHFA improve how it assesses risks posed by the Enterprises’ real estate
owned properties.2 In addition, OIG has identified shortfalls in FHFA’s examination coverage of
the Enterprises.3 This report continues OIG’s work by assessing FHFA’s oversight of the
Enterprises’ controls over multifamily underwriting, specifically in connection with two agency
examinations of the Enterprises’ multifamily asset quality.

OIG is authorized to conduct audits, evaluations, investigations, and other law enforcement
activities pertaining to FHFA’s programs and operations.4 As a result of its work, OIG may
recommend policies that promote economy and efficiency in administering FHFA’s programs
and operations, or that prevent and detect fraud and abuse in them. OIG believes that this report’s
recommendations (along with those in prior reports) will increase FHFA’s assurance that the
Enterprises are operating safely and soundly, and that their assets are preserved and conserved.

OIG appreciates the cooperation of all those who contributed to this audit, which was led by
Tara Lewis, Audit Director, who was assisted by Irene Porter, Audit Manager.



Russell A. Rau
Deputy Inspector General for Audits



1
 FHFA’s Oversight of Fannie Mae’s Single-Family Underwriting Standards (AUD-2012-003, March 22, 2012),
available at http://www.fhfaoig.gov/Content/Files/AUD-2012-003_0.pdf.
2
 FHFA’s Supervisory Risk Assessment for Single-Family Real Estate Owned (AUD-2012-005, July 19, 2012),
available at http://www.fhfaoig.gov/Content/Files/AUD-2012-005_2.pdf.
3
 Evaluation of Whether FHFA Has Sufficient Capacity to Examine the GSEs (EVL-2011-005, September 23, 2011),
available at http://www.fhfaoig.gov/Content/Files/EVL-2011-005.pdf.
4
 See the Housing and Economic Recovery Act of 2008, Public Law No. 110-289, which established OIG by
amending the Inspector General Act of 1978, Public Law No. 95-452.


        Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
                                                       5
BACKGROUND
Enterprises’ Role in Primary and Secondary Residential Mortgage Markets

Fannie Mae and Freddie Mac buy mortgages and related assets secured by single-family homes
and multifamily projects (e.g., apartment buildings). The Enterprises do not originate loans or
lend money directly to borrowers in the primary residential mortgage market. Instead, they
provide liquidity and stability in the secondary market where they buy mortgages originated by
lenders such as banks. The Enterprises may hold the mortgages that they buy in investment
portfolios or package them into mortgage-backed securities (MBS) for sale to investors.5
Meanwhile, as shown in Figure 1 below, lenders (also known as seller/servicers) can use the
proceeds from selling mortgages to originate more loans.

                          Figure 1: Enterprises’ Role in the Mortgage Market




With respect to multifamily loans, which tend to be valued at several million dollars each, the
Enterprises buy only loans that conform to their purchasing requirements.6 These requirements
include underwriting standards, which are guidelines to ensure the loans are safe and secure. For
example, generally both Enterprises’ guidelines require that multifamily loans cannot exceed
80% of the property value.

Below, OIG describes how the rising U.S. rental market along with the financial crisis positioned
the Enterprises as a dominant presence in the secondary multifamily mortgage market. Then,
OIG identifies some indications that the Enterprises have relaxed their underwriting standards.
Because one consequence of relaxed underwriting standards may be increased risk, OIG
concludes that FHFA’s ongoing supervision of the Enterprises’ multifamily businesses through
targeted examinations and other measures is imperative.

5
    Securities backed by multifamily properties are known as commercial MBS.
6
  Generally, multifamily properties are established as separate, special-purpose entities that are owned by one or
more key principals and investors, who are typically experienced commercial real estate managers. Structurally,
these entities are often limited liability companies or corporations that hold title to the real estate and owe money to
lenders as the result of mortgages on the properties, but which have no other assets or liabilities. Lenders frequently
require this structure as a condition of extending a mortgage loan because it insulates the collateral (multifamily
property) from claims by the creditors of the principals and investors.


           Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
                                                          6
Multifamily Housing Loan Market

When the financial crisis began in 2007, the number of homeowners fell and the number of
renters increased as renting a home became a more affordable option for many people. As shown
below, millions of households have switched from owning to renting. With the exception of a
brief respite in 2009, this trend continued through the first quarter of 2012.

                             Figure 2: Owners and Renters, 1990-20127




As the demand for rental housing increased, the private sector’s supply of financing for
multifamily housing—typically the source of most rental housing—dried up. Specifically, banks
and other entities tightened their lending in the wake of the financial crisis, their market share
contracted, and the overall volume of business decreased. On the other hand, the Enterprises’
market share increased.

Enterprises’ Presence in the Multifamily Loan Market

As shown below, from 2007 to 2009, multifamily loans purchased by the Enterprises as a
percentage of the overall market nearly tripled from 29% to 85%. Although the actual total dollar
value of loans they purchased did not increase significantly over this period, the Enterprises were
key to maintaining liquidity in a contracting multifamily housing market.




7
 Source: Mortgage Bankers Association, Multifamily Real Estate and Multifamily Real Estate Finance Markets
presentation (June 2012).


        Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
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    Figure 3: Originations and Subsequent Loan Purchases for the Enterprises and Total
                   Institutional Multifamily Lending (Dollars in Millions)8




By 2010, private capital began to return to the market and expanded multifamily mortgage
lending. Overall, from 2007 to 2011, outstanding multifamily housing debt grew from
$785 billion to $844 billion. As of December 2011, the Enterprises collectively held over a third
of the total outstanding debt from multifamily mortgage loans, or $285 billion (see Figure 4
below).




8
 Source: Mortgage Bankers Association: Multifamily Real Estate and Multifamily Real Estate Finance Markets
presentation (June 2012).


        Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
                                                       8
       Figure 4: Multifamily Mortgage Debt Outstanding 2007-2011 (Dollars in Millions)9



    $900,000
                                                                                                 Individuals and
    $800,000                                                                                     Others
                                                                                                 Life insurance
    $700,000                                                                                     companies
                                                                                                 Savings Institutions
    $600,000

                                                                                                 Commercial banks
    $500,000

    $400,000                                                                                     Private mortgage
                                                                                                 conduits
    $300,000                                                                                     Ginnie Mae

    $200,000                                                                                     Freddie Mac

    $100,000
                                                                                                 Fannie Mae

         $-
                  2007            2008            2009           2010            2011


Ultimately, however, the value of the Enterprises’ considerable multifamily mortgage holdings
depends on the underlying quality of the loans that they bought. As the financial crisis
demonstrated, if loans are not underwritten well, made to eligible borrowers, and supported by
adequate collateral, then the Enterprises’ investments may be at greater risk. Accordingly, the
Enterprises’ respective multifamily underwriting standards significantly influence the quality of
the loans that they buy.

Enterprises’ Relaxed Multifamily Underwriting Standards

OIG has found indications that the Enterprises relaxed some of their multifamily underwriting
standards from 2009 to 2011. This relaxation could cause increased risk in the Enterprises’
investment portfolios.10 For example, in 2009, based on dollar value, 34% and 40% respectively

9
 The chart includes assets that institutions hold in their non-consolidated trusts, which are not included in their
consolidated financial statements. Source: Federal Reserve, Economic Research & Data: Mortgage Debt
Outstanding (March 2012).
10
  It should be noted that from 2005 through 2010, the Enterprises’ multifamily loans had lower default rates than
loans purchased by competitors (with the exception of life insurers). See GAO, Mortgage Financing: Fannie Mae
and Freddie Mac’s Multifamily Housing Activities Have Increased, GAO-12-849 (September 2012), available at
http://www.gao.gov/assets/650/647800.pdf.


          Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
                                                         9
of Fannie Mae’s and Freddie Mac’s newly purchased multifamily loans were interest-only or
partial-interest only. But by 2011, the percentages of such higher-risk loans held by the
Enterprises had risen to:

            43% of Fannie Mae’s multifamily loans, valued at $10 billion, and

            62% of Freddie Mac’s multifamily loans, valued at $11 billion.

In total, through 2011, the Enterprises’ multifamily originations have increased to carry over
$21 billion in interest-only and partial-interest loans. These types of loans are riskier because,
initially, borrowers pay little to no principal, but payments can soar as the temporary partial-
interest or interest-only options expire. Then, borrowers have to start paying principal plus
interest, or repay the entire mortgage balance (i.e., a balloon payment). In addition, during the
loans’ interest payment phase, mortgage payments have done little or nothing to reduce the
loans’ principal, which exposes the Enterprises to greater risk than traditional loans that amortize
over time. The Enterprises have indicated, however, that their underwriting standards require the
borrower to qualify for a payment to include both principal and interest; thus, the risk of an
interest-only loan is mitigated. Nonetheless, the fact remains that the overall risk to the
Enterprises may be higher with such loans because little or no amortization of principal takes
place during the early years. In other words, interest-only and partial-interest loans still expose
the Enterprises to enhanced risk because the borrower’s equity does not necessarily increase over
time with recurring payments.

OIG also found that Fannie Mae made some changes to its Multifamily Selling and Servicing
Guide and Underwriting Standards between 2008 and 2011 that potentially increased risk (e.g.,
allowing borrowers to produce less income to cover the loan payment).11 For example, in 2010
Fannie Mae allowed interest-only periods to increase to 2.5 years for some of its 10 year loans.
Also, in 2011, Freddie Mac financed 207 loans with about $743 million of cash out—in other
words, borrowers received about $3.6 million in cash per loan. Essentially, these loans allow
borrowers to trade mortgage equity for cash and are riskier because they simultaneously increase
the borrowers’ debt, decrease their equity in the properties, and give them what can be a
substantial amount of cash that does not have to be reinvested in the project.12



11
   In August 2012, Fannie Mae tightened some of their underwriting standards for multifamily loans. Before
November 2012, FHFA did not review changes to the Enterprises’ underwriting standards before they were released
if they were within authorities delegated to managers by the Enterprises’ board of directors; after November 2012,
the agency updated its policies and procedures, and began to review all changes to the Enterprises’ underwriting
standards prior to issuance.
12
 As of the third quarter of 2012, Freddie Mac issued one underwriting policy change to reduce credit risk for
multifamily loans.


        Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
                                                      10
The business decision to relax or tighten underwriting standards balances risk and profit.
Tightening underwriting standards can lead to a portfolio with less risky loans, but may also
restrict lending, reduce potential sources of profit, and slow the secondary mortgage market. On
the other hand, relaxing underwriting standards may make more credit available for mortgage
loans, but it also can lead to future heavy losses from the present purchase of riskier loans.

FHFA’s examinations of asset quality, including selecting individual loans for review, are
intended to help ensure the Enterprises effectively manage these underwriting and other risks.

FHFA’s Supervision of the Enterprises’ Multifamily Businesses

FHFA’s Oversight Responsibilities

In July 2008, as the housing crisis deepened, the Housing and Economic Recovery Act of 2008
(HERA) was enacted and established FHFA as the Enterprises’ supervisor and regulator. Two
months later, in September, the agency placed Fannie Mae and Freddie Mac in conservatorships.
As conservator, FHFA has authority to preserve and conserve the Enterprises’ assets and
property, and it is responsible for restoring them to soundness and solvency.

Among other means, FHFA carries out its supervision and regulation by examining the
Enterprises to ensure that they operate safely and soundly, and that they comply with legal
requirements. The examinations are driven by FHFA’s risk assessments, which can yield a
variety of specific supervisory activities, such as ongoing monitoring. FHFA’s supervisory
process is cyclical in that risk assessments guide supervisory planning, which leads to
supervisory activities such as examinations. The examinations’ results can, in turn, identify
fruitful areas for future risk assessments.

FHFA’s Multifamily Risk Assessment and Examination Planning for the Enterprises

According to FHFA, a risk assessment is a planning exercise that sets out a risk-focused view of
the Enterprises.13 Risk assessments convert information obtained through supervisory activities
into a common understanding of the Enterprises’ existing and emerging risk characteristics.
Additionally, risk assessments feed the supervision workplans that govern all of the supervisory
activities conducted in the course of FHFA examinations.

Since 2009, FHFA has conducted annual risk assessments that identified various aspects of the
Enterprises’ multifamily housing business as major risk areas. As a result, FHFA has planned
and performed various supervisory activities for different aspects of multifamily housing, such as
the targeted examinations discussed below.

13
     FHFA, Supervisory Guide, Version 2.0 (September 8, 2009).


           Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
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FHFA’s Supervision Planning and Supervisory Activities

Depending on the issues identified during FHFA’s risk assessments, the agency can plan four
types of supervisory activities:

     1. Continuous supervision: routine day-to-day monitoring in real-time.

     2. Targeted examinations: focused reviews of all or parts of a single business line, a
        functional area, a specific risk or program area, a business process, or a supervisory
        concern.

     3. Special projects: all other supervision projects or assignments with specific tasks and
        goals.

     4. Remediation activities: supervisory actions to verify that an Enterprise has taken
        remedial steps required to operate safely and soundly.

Based on its continual risk assessments from 2009 to 2011, the agency initiated targeted
examinations of the Enterprises’ multifamily businesses. At the time of OIG’s audit, some of the
multifamily examinations had concluded while others were ongoing.

        Ongoing Examinations: Several of the ongoing examinations touch on multifamily
        underwriting. Because these examinations are in process, OIG did not review them.

        Concluded Examinations: Of the concluded examinations, some focused on multifamily
        underwriting.14

            FHFA initiated examinations focused on the Enterprises’ pricing of multifamily
             whole loans, which were initially included as part of OIG’s review. However, prior to
             rendering official conclusions, FHFA cancelled the examinations because of
             inadequate resources and the amount of time that had elapsed since the agency
             completed fieldwork.

            OIG concentrated its review on the remaining multifamily underwriting
             examinations, which focused on the quality of multifamily assets financed by the
             Enterprises.

14
   The concluded examinations that did not focus on underwriting and thus were outside the scope of OIG’s review
concentrated on the Enterprises’ asset and risk management. Regarding the examination related to risk management,
although multifamily underwriting was not the examination’s objective, FHFA identified concerns related to Fannie
Mae not monitoring or tracking exceptions and waivers from its multifamily underwriting standards that it grants to
its lenders. Because the concern derived from FHFA’s examination of Enterprise multifamily risk, OIG reviewed
FHFA’s conclusion related to this examination, but did not assess its overall examination work.


        Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
                                                      12
FHFA’s Multifamily Asset Quality Examinations

FHFA’s multifamily asset quality examinations—one at each Enterprise—focused on
underwriting controls and included in their scope:

          Level and trend in asset quality, growth, and portfolio changes;

          Adequacy of and compliance with underwriting policies and procedures;

          Underwriting, risk rating, waiver processes and controls, and pricing (which was
           eventually excluded because examiners determined it merited a separate
           examination);

          Problem loan identification and assignment of adverse risk ratings; and

          Adequacy of credit reserves for problem loans.

As part of its examinations of multifamily asset quality, FHFA’s respective examiners for Fannie
Mae and Freddie Mac separately selected samples of loans from each Enterprise’s portfolio to
determine if they complied with the Enterprise’s underwriting standards.

Results of the Asset Quality Examinations

In January 2012, FHFA identified significant concerns for the Enterprises’ management to
address. For example, from the Fannie Mae examination, FHFA noted issues related to
underwriting assumptions and appraisal weaknesses. Meanwhile, the Freddie Mac examination
found significant concerns such as the Enterprise’s management of potentially troubled assets.

FHFA raised its concerns to Fannie Mae and Freddie Mac. As of February 2013, FHFA has
accepted Fannie Mae’s resolution strategies for all multifamily asset quality concerns and is
monitoring the implementation of the strategies. In addition, FHFA has concluded Freddie Mac
fully remediated the agency’s asset quality concerns.

Sampling Methodology for the Asset Quality Examinations

Although FHFA’s Fannie Mae and Freddie Mac examination teams uncovered significant issues
that warranted corrective action, they used different sampling methodologies when examining
each Enterprise. OIG attributes the teams’ disparate approaches to a lack of FHFA guidance on
loan sampling.

Regarding their different sampling methodologies, FHFA’s Fannie Mae examiners used a
random sample generator to select 60 multifamily loans fitting various criteria from the
Enterprise’s portfolio. The criteria included loans with various risk ratings (including

       Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
                                                     13
delinquencies), loans that had and had not passed through the Enterprise’s quality controls, and
loans for $10 million and above. Subsequently, the examiners exercised their judgment and
reduced their review to 30 loans due to resource constraints. In spite of the reduction, the
examiners’ sample still included multifamily loans ranging in value from $500,000 to
$56 million. That sample may have been adequately representative, but the examiners did not
retain sufficient documentation to permit OIG to assess fully their sampling methodology.

FHFA’s Freddie Mac examiners followed a different sampling strategy for the 17 loans they
selected for review. They excluded over half of the Enterprises’ multifamily loans (829 loans,
totaling $11.5 billion) from their selection pool because, according to the lead examiner, the
loans had additional “nuances,” such as credit enhancements.15 However, some of these nuanced
loans had significant risks. For example, Freddie Mac delegated to lenders the underwriting
responsibility for its targeted affordable housing loans, which can have lower expected returns
and relaxed underwriting criteria. Further, FHFA’s examiners did not ensure that the selected
loans included loans that were delinquent or at risk of delinquency.

As a consequence of their exclusion—based on the overall population of loans—FHFA’s Freddie
Mac examiners selected a disproportionate number of lower value loans. The overall loan
population included loans ranging from $52,000 to $205 million, averaging $13 million.
However, of the 17 loans selected for the examination, only one was above the average dollar
value of Freddie Mac’s loan population.

The Freddie Mac loans selected for review by FHFA may not be sufficiently representative.
Industry standards suggest that loan portfolio reviews should include representative or
proportional samples. For example, in its risk management examination manual, the Federal
Deposit Insurance Corporation (FDIC) directs that the percentage of the portfolio selected for
review should provide reasonable assurance that all major credit risks have been identified.16
Similarly, the American Institute of Certified Public Accountants holds that sample “items
should be selected in such a way that the sample can be expected to be representative of the
population. Therefore, all items in the population should have an opportunity to be selected.”17
Additionally, when examining underwriting standard compliance, the Office of the Comptroller
of the Currency (OCC) suggests using proportional sampling, which selects larger loans
according to their presence in the overall loan population.18 Further, FHFA’s manual for

15
  Credit enhancements are added loan requirements, such as mortgage insurance, that mitigate the Enterprises’
exposure to potential losses in the event of a default.
16
     FDIC, Risk Management Manual of Examination Policies, section 3.2, pg. 3 (December 2004).
17
 American Institute of Certified Public Accountants, Statements on Auditing Standards No. 39, Audit Sample
Manual, sec. 350, pg. 516 (June 1983).
18
     OCC, Sampling Methodologies, pgs. 5-6 (August 1998).


           Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
                                                         14
examining Federal Home Loan Banks’ investment portfolios generally agrees with the
aforementioned industry standard that “the sample should generally include investments in all
major categories.”19

In the finding that follows, OIG discusses how FHFA’s Enterprise examinations can benefit from
guidance about how to select samples sufficient to strengthen the agency’s assurance in its
conclusions about the loan population under review. OIG concludes that FHFA will benefit from
considering industry sampling standards when they are relevant and developing sampling
selection guidelines to benefit its examiners.




19
     FHFA, Federal Home Loan Banks’ Investment Portfolio Management Examination Manual, pg. 38 (April 2007).


           Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
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FINDING
FHFA can increase its confidence in the efficacy of loan reviews during targeted examinations
by providing its examiners with guidance about how to select samples. Lacking such instruction,
FHFA examiners conducted targeted examinations of the Enterprises (that were supposed to
have identical scopes and objectives) that varied significantly in terms of how samples of loans
for review were selected for each Enterprise. Consequently, FHFA’s selection of loans in one of
the examinations may not have been sufficient to give the agency reasonable assurance of the
multifamily loans’ asset quality—one of the examination’s objectives.

Based on information provided to OIG, the agency’s selection of 30 Fannie Mae loans from
various risk categories and dollar values may have been adequately representative of Fannie
Mae’s loan population. However, FHFA’s examiners did not retain documentation sufficient to
assess fully the merit of their sampling methodology, such as the precise scope and composition
of Fannie Mae’s universe of multifamily loans. In future sampling, retaining such information
will help the agency support its sampling approach and defend its conclusions.

On the other hand, FHFA’s examination of Freddie Mac’s asset quality may not have included a
representative sample of loans. The sample of 17 loans excluded over half of the Enterprise’s
multifamily loans—including major risk areas, such as loans that are subject to relaxed
underwriting standards. The examiners also disproportionately sampled smaller loans, selecting
only one loan that was valued above $13 million, which is the average value of a Freddie Mac
multifamily loan. Not only are larger loans inherently more risky—one $90 million loan in
default may be worse than nine $5 million loans in default—but Freddie Mac’s underwriting
requirements become more restrictive as loan values and risks rise. Because the largest loan
FHFA examined was $18 million, whereas the overall population included loans up to $205
million, these more restrictive underwriting standards were effectively outside of the
examination’s review.

For example, as shown in Figure 5 below, Freddie Mac loan values determine approval
authority: the larger the loan, the higher the approval needed. Additionally, other increasingly
restrictive underwriting requirements apply as loans become riskier. For instance, Freddie Mac’s
independent valuation unit must review loans above $35 million.




       Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
                                                     16
                   Figure 5: Freddie Mac’s Multifamily Loan Approval Authority20




By not selecting larger dollar value loans, FHFA may have excluded important underwriting
controls from its examination.

As discussed above, several industry peers—ranging from FDIC to OCC—provide sample
selection guidance for reviewing loans and generally agree that sampling should be
representative or proportional. That is, every major risk area should be present for selection, or
the selection itself should be proportional so that larger loans have a chance of being selected
equal to their presence in the overall loan population.

OIG believes that FHFA’s examiners will benefit from similar guidance tailored to the agency’s
mission and needs, which will provide increased confidence that FHFA’s loan samples are
commensurate with the overall loan population under review and adequate to answer the
examinations’ objectives.




20
     Freddie Mac, Multifamily Securitization presentation, pg. 15 (January 2013).


           Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
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CONCLUSION
Thorough, comprehensive examinations are important because they form the basis for FHFA’s
opinions on the safety and soundness of the Enterprises. FHFA examinations of the Enterprises’
controls over underwriting of multifamily loans are also important to FHFA’s mission to help
stabilize the housing finance market and to ensure that additonal risks assumed by the
Enterprises are properly managed and that losses are minimized. These examinations are
particularly critical to supervising risk given indications that the Enterprises are expanding their
multifamily books of business and have relaxed some of their underwriting standards in the past.
These standards have a direct, material impact on the level of risk associated with their
multifamily loans. Thorough FHFA oversight is key to balancing these risks with the potential
returns in order to ensure that the taxpayers’ interests are protected. Accordingly, the
recommendations below are designed to help enhance the effectiveness and efficiency of
FHFA’s examinations of the Enterprises’ multifamily businesses.




       Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
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RECOMMENDATIONS
OIG recommends that FHFA:

   1. Update its examination guide (Supervision Reference and Procedures Manual, Credit
      Risk-Multifamily), in consideration of industry standards, to include qualitative guidance
      for examiners to follow when determining the sampling size and testing coverage of loan
      files.
   2. Require examiners to maintain documentation adequate to support adherence to the
      sampling methodology developed in Recommendation 1.




      Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
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SCOPE AND METHODOLOGY
This performance audit’s objective was to assess FHFA’s supervisory oversight of the
Enterprises’ controls over underwriting of multifamily loans with a specific focus on FHFA’s
targeted examinations of the Enterprises’ multifamily asset quality.

OIG performed its fieldwork for this audit from January 2012 through November 2012. OIG
conducted this audit at FHFA’s and Fannie Mae’s offices in Washington, D.C., and Freddie
Mac’s office in McLean, Virginia. OIG interviewed FHFA, Fannie Mae, and Freddie Mac
personnel. OIG relied on computer-processed and hardcopy data from FHFA, Fannie Mae, and
Freddie Mac. This included data contained in FHFA’s electronic document repository.
Computer-processed data was used for background purposes only and not to support the audit
conclusion.

To achieve its objective, OIG:

          Assessed the adequacy of FHFA’s underwriting examination programs;

          Judgmentally selected and tested multifamily underwriting loans reviewed by FHFA;

          Analyzed selected changes in Enterprise risk limits as they apply to multifamily
           underwriting; and,

          Interviewed FHFA officials on the examination risk assessment, planning,
           performing, supervising, and reporting for multifamily underwriting.

OIG assessed the internal controls related to its audit objective. Internal controls are an integral
component of an organization’s management that provides reasonable assurance that the
following objectives are achieved:

          Effectiveness and efficiency of operations;

          Reliability of financial reporting; and,

          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 on this
performance audit, OIG considers weaknesses in FHFA’s supervisory oversight of the asset
quality of multifamily housing loans financed by Fannie Mae and Freddie Mac to be significant

       Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
                                                     20
in the context of the audit’s objective. Additionally, OIG identified other less significant matters
that came to its attention during the audit. These matters were communicated separately in writing
to FHFA in an audit memorandum.

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 OIG’s finding and conclusions
based on the audit objective. 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-2013-004 • February 21, 2013
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APPENDIX A:
FHFA’s Comments on Finding and Recommendations




   Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
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Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
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APPENDIX B:
OIG’s Response to FHFA’s Comments

On December 17, 2012, FHFA provided comments to a draft of this report agreeing with both
recommendations and identifying FHFA actions to address each recommendation. OIG considers
the actions sufficient to resolve the recommendations, which remain open until OIG determines
that agreed upon corrective actions are completed and responsive to the recommendations. 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-2013-004 • February 21, 2013
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APPENDIX C:
Summary of Management’s Comments on the
Recommendations
This table presents management’s responses to the recommendations in OIG’s report and the
status of each recommendation as of the date when the report was issued.

                                                    Expected
                 Corrective Action: Taken or       Completion        Monetary       Resolveda      Open or
 Rec. No.                  Planned                    Date           Benefits       Yes or No      Closedb
    1.           FHFA will develop                 12/31/2013          $0             Yes           Open
                 examination guidance
                 regarding sample selection
                 and will prompt examiners
                 to consult colleagues in the
                 risk modeling group in the
                 Division of Supervision
                 Policy and Support for help
                 identifying the appropriate
                 sampling criteria consistent
                 with the examination
                 scope.
     2.          FHFA will include                  12/31/2013           $0            Yes           Open
                 documentation of the
                 sampling method used and
                 sample size as part of the
                 work program.
   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 OIG monetary
benefits, a different amount, or no ($0) amount. Monetary benefits are considered resolved as long as management
provides an amount.
(b) Once OIG determines that the agreed-upon corrective actions have been completed and are responsive to the
recommendations, the recommendations can be closed.




          Federal Housing Finance Agency Office of Inspector General • AUD-2013-004 • February 21, 2013
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ADDITIONAL INFORMATION AND COPIES


For additional copies of this report:

         Call OIG at: 202-730-0880

         Fax your request to: 202-318-0239

         Visit the OIG 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: 1-800-793-7724

         Fax your written complaint to: 202-318-0358

         E-mail us at: oighotline@fhfa.gov

         Write to us at: 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-2013-004 • February 21, 2013
This report contains nonpublic information and should not be disseminated outside FHFA without FHFA-OIG’s written approval.
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