oversight

CohnReznick LLP's Independent Audit of FHFA's Oversight of Enterprise Monitoring of the Financial Condition of Mortgage Insurers

Published by the Federal Housing Finance Agency, Office of Inspector General on 2014-05-08.

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

           Federal Housing Finance Agency
               Office of Inspector General




CohnReznick LLP’s Independent Audit
  of FHFA’s Oversight of Enterprise
Monitoring of the Financial Condition
        of Mortgage Insurers




    Audit Report  AUD-2014-013  May 8, 2014
              FHFA’s Oversight of Enterprise Monitoring of the
              Financial Condition of Mortgage Insurers

              Why OIG Had CohnReznick Do This Audit
              The Housing and Economic Recovery Act of 2008 created the Federal Housing
              Finance Agency (FHFA or the Agency) in July 2008. FHFA’s mission is to
              provide effective supervision, regulation, and housing mission oversight of
 At A         Fannie Mae and Freddie Mac (collectively, the Enterprises) to promote their
Glance        safety and soundness. Since September 2008, both Enterprises have been in
              FHFA conservatorships with FHFA assuming management responsibilities to
  ———         preserve and conserve their assets.

May 8, 2014   The Enterprises are restricted by their charters to only purchase loans
              with loan-to-value ratios over 80% if the loans include a form of credit
              enhancement. The Enterprises typically require mortgage insurance
              underwritten by private mortgage insurers as a credit enhancement to reduce
              the amount of losses in the event of borrower default. The Enterprises operate
              in the secondary mortgage market by purchasing residential mortgage loans
              from lenders, thus receiving the benefit of mortgage insurance. As of June 30,
              2013, the Enterprises held over $587 billion in single-family residential
              mortgage loans insured by private mortgage insurance companies. FHFA as
              the regulator for Fannie Mae and Freddie Mac has the responsibility to perform
              oversight of the Enterprises’ monitoring of the financial condition of the
              mortgage insurers with which they conduct business. Additionally, as
              conservator for the Enterprises, FHFA has management responsibilities
              and authorities to operate the Enterprises with a focus on preserving and
              conserving their assets.

              In March 2013, FHFA’s Office of Inspector General (OIG) contracted with
              CohnReznick LLP (CohnReznick) to perform an audit of FHFA’s oversight of
              the financial condition of the mortgage insurers used on loans purchased by the
              Enterprises and their risk exposure.

              What CohnReznick Found
              CohnReznick found that FHFA has gone through a number of iterations in its
              oversight and governance structure regarding Enterprise relationships with
              mortgage insurers in response to the deteriorating financial condition of
              certain mortgage insurers and the related loss exposure to the Enterprises. In
              particular, FHFA has actively pursued implementation of new master policy
              agreements and eligibility requirements for mortgage insurers. CohnReznick
              concluded that FHFA has opportunities to further strengthen its oversight of
              the Enterprises’ monitoring of the financial condition of mortgage insurers and
              their related risk exposure. Specifically, CohnReznick identified that:

                    FHFA can better coordinate oversight of the risk posed by mortgage
                     insurers in a weakened financial condition through issuance of a formal
                     oversight plan that defines the roles and responsibilities of the various
                     FHFA components and the Enterprises in this area. As of June 30,
                     2013, these distressed mortgage insurers were potentially responsible
 At A                for up to $49 billion in the event of borrower defaults – over a third of
Glance               the coverage to both Enterprises.

  ———               FHFA can improve its oversight of the approval of new mortgage
                     insurers. CohnReznick determined that FHFA delegated the approval
May 8, 2014          decision for a new mortgage insurer to the Enterprises. Such delegated
                     approval is limited to counterparties where there are no reasonably
                     foreseeable material increases in operational risk, which is generally
                     not the case for a new mortgage insurer. Additionally, FHFA does not
                     have a formal process for evaluating new mortgage insurers, including
                     Enterprise risk assessments and justification for conditional approval
                     requirements. Given the importance of mitigating the risk posed by new
                     mortgage insurers, the direct involvement of FHFA in the review and
                     approval process would strengthen governance over these decisions.

              What CohnReznick Recommends
              While FHFA has performed oversight and monitoring of mortgage insurance
              related activities, there continue to be opportunities for FHFA to enhance these
              activities. CohnReznick recommends that FHFA take the following actions:
              (1) establish policies, procedures, and processes to execute FHFA’s oversight
              of the Enterprises’ monitoring of business conducted with mortgage insurers;
              (2) develop specific criteria, and update the letter of instruction accordingly,
              that classifies new mortgage insurers as non-delegated activities that require
              FHFA approval; and (3) develop a methodology for FHFA’s review of
              new mortgage insurers and ensure procedures performed are adequately
              documented and support the conclusions reached during the review.

              FHFA generally agreed with the first recommendation but did not provide
              responsive comments to the second and third recommendations, which OIG
              considers unresolved.
      PREFACE ...................................................................................

   This is one in a series of audits, evaluations, and special reports published as part of the
   Federal Housing Finance Agency (FHFA or Agency) Office of Inspector General’s (OIG)
   oversight responsibilities to promote economy, effectiveness, and efficiency in the
Synopsis
   administration of FHFA’s programs. The objective of this performance audit was to assess
   FHFA’s oversight of the Enterprises’ monitoring of the financial condition of mortgage
  ———
   insurers.
May 1,
    OIG2014
         contracted with CohnReznick, an independent certified public accounting firm, to
      conduct this performance audit. CohnReznick is responsible for the attached auditor’s report,
      dated May 2, 2014, and the findings and conclusions expressed in that report. In connection
      with the contract, OIG reviewed CohnReznick’s report and related audit documentation,
      inquired of its representatives, and performed other monitoring activities in order to fulfill
      OIG’s responsibility to ensure the firm adhered to Generally Accepted Government Auditing
      Standards (GAGAS). OIG’s review found no instances where the firm did not comply, in all
      material respects, with GAGAS. OIG’s review, as differentiated from an audit in accordance
      with GAGAS, was not intended to enable OIG to report conclusions based on the audit
      objective.

      CohnReznick’s audit report makes three recommendations to FHFA to enhance oversight and
      monitoring procedures related to the risks posed to the Enterprises from conducting business
      with mortgage insurers. Refer to Appendix A for OIG’s evaluation of FHFA’s responses to
      the CohnReznick recommendations. Questions on this report can be directed to the OIG at
      (202) 730-0880. OIG appreciates the assistance of all those who contributed to the audit.




      Russell A. Rau
      Deputy Inspector General for Audits




                                                      iv
      Independent Audit of FHFA’s Oversight of
Synopsis  Enterprise Monitoring of the Financial
  ———
 May 1, 2014
             Condition of Mortgage Insurers

          Fiscal Years September 2008 to May 2013



                          May 2, 2014




                           Point of Contact:
                       Frank D. Banda, Partner
                    7501 Wisconsin Avenue, Ste. 400
                         Bethesda, MD 20814
Synopsis
  ———
May 1, 2014




              vi
Synopsis
  ———
May 1, 2014




              vii
TABLE OF CONTENTS ................................................................

PREFACE ...................................................................................................................................... iv

CONTEXT .......................................................................................................................................1
      Background...............................................................................................................................1
              Mortgage Insurers .............................................................................................................1
              Receivership (Run-off) and Deferred Payment Obligation ..............................................3
              New Mortgage Insurers ....................................................................................................3
              FHFA Oversight ...............................................................................................................4

OBJECTIVES ..................................................................................................................................7

FINDINGS .......................................................................................................................................8
      1.     FHFA Can Further Strengthen Its Oversight of the Risks Posed by Mortgage
             Insurers to the Enterprises .................................................................................................8
      2.     FHFA Should Establish Criteria Defining the Review and Approval of New
             Mortgage Insurers ...........................................................................................................11

CONCLUSIONS............................................................................................................................13

RECOMMENDATIONS ...............................................................................................................13

SCOPE AND METHODOLOGY .................................................................................................14
      Scope ......................................................................................................................................14
      General Methodology .............................................................................................................14

APPENDIX A ................................................................................................................................15
      OIG’s Response to FHFA’s Comments .................................................................................15

APPENDIX B ................................................................................................................................18
      FHFA’s Comments on the Findings and Recommendations .................................................18

APPENDIX C ................................................................................................................................21
      Summary of Management’s Comments on the Recommendations .......................................21

ADDITIONAL INFORMATION AND COPIES .........................................................................23

                                                                      viii
CONTEXT ..................................................................................

Background

      Mortgage Insurers

As of June 30, 2013, the Enterprises conducted business with seven mortgage insurers.1 In
order to qualify to conduct business with the Enterprises, a mortgage insurer must meet the
Enterprises’ established operating standards, referred to as eligibility requirements. The
current versions of the eligibility requirements were effective in 2005 for Fannie Mae and
2008 for Freddie Mac.2

The requirements include standards on the mortgage insurers’ risk-to-capital ratios and credit
ratings, as assigned by Standard and Poor’s, Moody’s, and Fitch.3 Additionally, after a
mortgage insurer qualifies to conduct business with the Enterprises, it must submit an annual
certification of its compliance with the eligibility requirements.4 A mortgage insurer that does



1
    The audit scope period covered September 2008 to May 2013; however, June 30, 2013,
    was used as a consistent benchmark since relevant quarterly information was available
    as of that date. During the scope period, three mortgage insurers were placed into
    receivership and a new mortgage insurer was added to the list of qualified mortgage
    insurers.
2
    Fannie Mae, Qualified Mortgage Insurer Approval Requirements (December 2003).
    Accessed: March 18, 2014, at
    www.fanniemae.com/content/eligibility_information/mortgage-insurers-approval-
    requirements.pdf. Freddie Mac, Private Mortgage Insurer Eligibility Requirements
    (January 2008). Accessed: March 18, 2014, at
    www.freddiemac.com/singlefamily/pdf/mireqs.pdf.
3
    Risk-to-Capital – The ratio of net risk in force an insurer has relative to its total
    policyholders’ surplus.
    Freddie Mac, “Glossary,” Private Mortgage Insurer Eligibility Requirements, at G-6
    (January 2008). Accessed: March 18, 2014, at
    www.freddiemac.com/singlefamily/pdf/mireqs.pdf.
4
    Annual Certification – Requirement in the Enterprises’ eligibility requirements that states
    each approved mortgage insurer must submit a Certificate of Compliance by April 15.
    Freddie Mac, “Exhibit 3, Annual Certification,” Private Mortgage Insurer Eligibility
    Requirements, at E-3 (January 2008). Accessed: March 18, 2014, at
    www.freddiemac.com/singlefamily/pdf/mireqs.pdf. Fannie Mae, “Maintaining Approval,”
    Qualified Mortgage Insurer Approval Requirements, at 4 (December 2003). Accessed:



           Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   1
not comply with these requirements may be suspended or terminated from doing business
with the Enterprises, decisions that are left to the Enterprises’ discretion. Mortgage insurers
must also execute master policy agreements with each lender. The master policy agreements
define the terms and conditions of the mortgage insurance between the mortgage insurer and
the insured (typically the lender).

As part of the Conservatorship Strategic Plan: Performance Goals for 2013 (2013
Conservatorship Scorecard), the Enterprises were required to develop uniform master policy
agreements and eligibility requirements.5 On December 2, 2013, FHFA announced that the
master policy agreements were aligned and updated to strengthen requirements over the
following areas:
                Loss mitigation;
                Claims;
                Assurance of coverage; and
                Enhanced communication.6

The new master policy agreements will be filed with the state insurance regulators for review
and approval. Upon completion, the new master policy agreements will be executed and
effective for all loans purchased by the Enterprises, which FHFA anticipates will occur by
mid-2014.

Additionally, as of December 2013, drafts of the revised eligibility requirements are under
review by FHFA and the Enterprises. Once this review is complete, the revised drafts will be
available for public comment prior to being issued in final form and implemented.




    March 18, 2014, at www.fanniemae.com/content/eligibility_information/mortgage-
    insurers-approval-requirements.pdf.
5
    Federal Housing Finance Agency, “Maintain Foreclosure Prevention Activities and Credit
    Availability for New and Refinanced Mortgages,” Conservatorship Strategic Plan:
    Performance Goals for 2013, at 3. Accessed: February 17, 2014, at
    http://www.fhfa.gov/AboutUs/Reports/ReportDocuments/2013EnterpriseScorecard_508.pdf.
6
    Federal Housing Finance Agency, FHFA Announces Overhaul of Fannie Mae and Freddie
    Mac Mortgage Insurance Master Policy Requirements (December 2, 2013). Accessed:
    February 17, 2014, at http://www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Announces-
    Overhaul-of-Fannie-Mae-and-Freddie-Mac-Mortgage-Insurance-Master-Policy-
    Requirements.aspx.



             Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   2
      Receivership (Run-off)7 and Deferred Payment Obligation8

State insurance departments regulate mortgage insurers and usually require them to maintain a
risk-to-capital ratio of 25:1.9 When a mortgage insurer can no longer meet the state’s risk-to-
capital ratio requirements, they may be placed into receivership, or run-off, by the state regulator
and may no longer be eligible to conduct new business.

Because of their financial condition and inability to meet the state’s minimum risk-to-capital
ratio requirement of 25:1, five of the ten mortgage insurers eligible to conduct business with the
Enterprises are considered financially weakened (see Table 2, page 9). Additionally, three of
the five financially weakened mortgage insurers—PMI Mortgage Insurance Co. (PMI), Triad
Guaranty Insurance Corporation (Triad), and Republic Mortgage Insurance Company (RMIC)—
are in run-off and no longer able to issue new mortgage insurance policies. Moreover, these
mortgage insurers have established deferred payment obligation (DPO) agreements that require a
percentage of their claims obligations, to the Enterprises, to be deferred.

      New Mortgage Insurers

In January 2013, Fannie Mae and Freddie Mac submitted requests for approval of a new
mortgage insurer. Prior to requesting approval from the Agency, the Enterprises conducted
independent six- to nine-month reviews of the operations and financial condition of the
proposed new mortgage insurer—National Mortgage Insurance Company (National MI).
The Enterprises’ reviews of the proposed new mortgage insurer identified various risks,
including:

7
    Receivership (Run-off) – A court order whereby all the property subject to dispute in a
    legal action is placed under the control of an independent receiver. In this case, the
    mortgage insurers who could no longer meet the risk-to-capital ratio requirements were
    placed into run-off by the state regulator. Mortgage insurers in run-off are prevented from
    conducting new business with the Enterprises.
8
    Deferred Payment Obligations – For mortgage insurers in receivership, the state regulator
    delays full payment of all claims to ensure all claims receive a partial payment. The unpaid
    claim balance is referred to as the deferred payment obligation.
9
    Mortgage insurers are generally required to hold a risk-to-capital ratio of at least 25:1 (i.e.,
    for every $25 of risk in force, the mortgage insurer must hold at least $1 of capital) to
    cover unexpected losses.
    United Guaranty, “Background and Scope of Analysis,” RE: Comment on Building a New
    Infrastructure for the Secondary Mortgage Market, at 2 (December 3, 2012). Accessed:
    March 18, 2014, at
    http://www.fhfa.gov/PolicyProgramsResearch/Policy/Documents/Securitization-
    Infrastructure/12.03.2012.United_Guaranty_FHFA_Comment_Letter_-_12-3-12.PDF.



           Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014    3
        The state of Arizona had filed a lawsuit against the new mortgage insurer citing unfair
         business practices related to current employees (these employees were formerly at a
         mortgage insurer domicile in Arizona, which is currently under state receivership);
        The new mortgage insurer had not obtained licensing to insure loans in all 50 states and
         the District of Columbia; and
        The mortgage insurer had no mortgage insurance industry footprint.

Based on their respective reviews, the Enterprises determined that a conditional approval
should be given to National MI, of which a selection of the required provisions is included in
the following (see Table 1, below):

                   TABLE 1: NATIONAL MI’S CONDITIONAL APPROVAL REQUIREMENTS
           Fannie Mae’s Conditions                             Freddie Mac’s Conditions
 National MI must maintain at all times total         National MI must maintain at all times a
 statutory capital (i.e., policyholder surplus        minimum $150 million statutory capital,
 plus statutory contingency reserves) of at           excluding loss reserves.
 least $150 million.
 National MI will not pay any dividends to            National MI can only be involved in standard
 affiliates or its holding company until              “plain-vanilla” mortgage products, i.e., only
 December 31, 2015.                                   primary first-lien mortgage insurance.
 National MI will maintain a risk-to-capital          National MI must maintain a maximum risk-
 ratio not to exceed 15:1 through December            to-capital ratio of 15:1 for the first three years.
 31, 2015.                                            Any changes require Freddie Mac’s approval.

 National MI must obtain Fannie Mae’s prior           All nonstandard (bulk, pool, etc.) transactions
 written approval of any risk novation or             must be reported to Freddie Mac for review
 commutation until December 31, 2015.                 and approval.

     FHFA Oversight

FHFA’s Division of Enterprise Regulation (DER) is responsible for the risk-based Enterprise
supervision program and is governed by the Division of Enterprise Regulation Supervision
Handbook (Handbook), updated July 16, 2009, which is currently in its second edition (2.1).10
The Handbook defines policies and procedures that DER should implement to perform the


10
  Federal Housing Finance Agency, “Background,” Division of Enterprise Regulation
Supervision Handbook 2.1, at 6 (June 16, 2009). Accessed: March 18, 2014, at
http://www.fhfa.gov/SupervisionRegulation/FannieMaeandFreddieMac/Documents/DER_Super
vision_Handbook_2.1_508.pdf.




          Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014          4
requisite supervision and monitoring activities. DER provides oversight of the Enterprises and
ensures coordination among all of the FHFA supervisory functions. DER’s oversight function
includes the management of mortgage insurers by the Enterprises.

DER also plans and conducts examinations of the Enterprises, prepares and issues reports of the
examinations, and seeks preventative and corrective actions as appropriate. Examination
procedures are comprised of internal and external activities, including financial safety and
soundness monitoring. Special reviews/projects are conducted to focus on specific issues of
concern in coordination with other supervision functions upon request.11

In addition to the Handbook, FHFA also uses the letter of instruction as an oversight and
monitoring tool for the Enterprises in conservatorship.12 The letter of instruction, written by
FHFA’s Office of the Director, outlines matters that are not delegated to the Enterprises’
Boards of Directors and require FHFA approval, as well as matters that require notice to
FHFA. The first letter was issued to the Enterprises on November 24, 2008, and was
subsequently updated and re-issued on November 15, 2012.

In 2011, FHFA established the Mortgage Insurance Working Group (MIWG) to coordinate
information sharing among the various divisions within the Agency involved in mortgage
insurance, though the individual divisions continued to work with the Enterprises. 13 MIWG
held weekly, monthly, and ad hoc meetings with the Enterprises to discuss mortgage
insurance activities and events. MIWG, which was disbanded during July 2013, was not
designed to issue directives to the Enterprises or create an oversight plan to address the
financial condition of mortgage insurers. Subsequent to the disbandment of MIWG, mortgage




11
     Federal Housing Finance Agency, “Examination,” Division of Enterprise Regulation
     Supervision Handbook 2.1, at 9 (June 16, 2009). Accessed: March 18, 2014, at
     http://www.fhfa.gov/SupervisionRegulation/FannieMaeandFreddieMac/Documents/DER_
     Supervision_Handbook_2.1_508.pdf.
12
     Letter of instruction, FHFA Office of the Director, November 15, 2012 – The letter of
     instruction defines the roles and responsibilities of the Agency, the board of directors, and
     management at the Enterprises. The first letter was provided to the Enterprises on
     November 24, 2008; this letter was subsequently updated on November 15, 2012.
13
     MIWG included representatives from the following FHFA divisions: the Office of
     Strategic Initiatives, Office of Conservator Operations, Office of General Counsel (OGC),
     Division of Housing Mission and Goals (DHMG), DER, Division of Supervision Policy
     and Support (DSPS), and Office of Systemic Risk and Market Surveillance.



            Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   5
insurance oversight activities continued with individual divisions within the Agency and the
executive Mortgage Insurance Steering Committee.14




14
     Established in January 2013, the Mortgage Insurance Steering Committee is responsible
     for providing guidance to the FHFA divisions for mortgage insurance related matters.



           Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   6
OBJECTIVES ..............................................................................

   The overall objective of this audit was to assess FHFA’s oversight of the Enterprises’
   monitoring of the financial condition of mortgage insurers. The specific objectives were to
   assess:

           whether FHFA has evaluated the risks associated with mortgage insurers’ financial
            condition;

           FHFA’s oversight efforts regarding the new master policy agreements and eligibility
            requirements;

           whether FHFA evaluated the Enterprises’ requirements for conducting business with
            new mortgage insurers; and

           whether FHFA assessed whether the Enterprises should be conducting business with
            mortgage insurers in a weakened financial condition.




          Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   7
FINDINGS .................................................................................

1. FHFA Can Further Strengthen Its Oversight of the Risks Posed by Mortgage Insurers
   to the Enterprises

During the period September 2008 to May 2013, FHFA’s annual supervisory plans did not
include the risk exposure to the Enterprises from conducting business with financially weakened
mortgage insurers. Although FHFA was performing ongoing mortgage insurance related
oversight procedures, including targeted examinations and special projects, FHFA should have
documented and reported their evaluation of the financial risks to the Enterprises for doing
business with mortgage insurers in a weakened financial condition. In addition, FHFA should
have issued formal guidance, directives, and/or instructions to the Enterprises for conducting
business with mortgage insurers in a weakened financial condition.

FHFA’s coordinated oversight of the risks posed by mortgage insurers in weakened financial
condition could have been strengthened through the issuance of a formal oversight plan that
includes defining roles and responsibilities of the various components of FHFA and the
Enterprises. Such an oversight plan should clearly define the policies and procedures used to
achieve FHFA objectives concerning Enterprise use of mortgage insurance as a credit
enhancement and risk management tool. Well-defined policies and procedures are particularly
important as FHFA and the Enterprises proceed with the implementation of new master policy
agreements and eligibility requirements for mortgage insurers.

As illustrated in Table 2 (below), as of June 30, 2013, the five financially weakened mortgage
insurers represented $202 billion of the $587 billion in Enterprise exposure (about 34%).15 In
addition, the maximum amount of loss recovery from the five financially weakened insurers is


15
     In this case, the exposure relates to insurance in force, which represents the unpaid
     principal balance of single-family loans in the Enterprises’ guaranty books of business
     covered under the applicable mortgage insurance policies. The five financially weakened
     mortgage insurers are PMI, RMIC, Triad, Genworth, and CMG.
     Fannie Mae “Table 45: Mortgage Insurance Coverage,” Form 10-Q for the Quarterly
     Period Ended June 30, 2013, at 72. Accessed: February 17, 2014, at
     www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2013/q22013.pdf.
     Freddie Mac, “Table 50 — Mortgage Insurance by Counterparty,” Form 10-Q for the
     Quarterly Period Ended June 30, 2013, at 83. Accessed: February 17, 2014, at
     http://api40.10kwizard.com/cgi/convert/pdf/FEDERALHOMELOANMORTGAGECORP
     -20130807-10Q-
     20130630.pdf?ipage=9066647&xml=1&quest=1&rid=23&section=1&sequence=-
     1&pdf=1&dn=1.



           Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   8
$49 billion of a total of $144 billion, which is also about 34%.16 Given the amount of exposure
to mortgage insurers, the Enterprises have identified that they may incur losses as a result of
mortgage insurance claims not being paid in full or at all and that there is increased concentration
risk due to the smaller pool of financially sound insurers. 17

         TABLE 2. ENTERPRISE RISK EXPOSURE FOR EACH MORTGAGE INSURER AS OF JUNE 30, 2013

                                                                Insurance in Force        Risk in Force
                                                          18                      19                     20
       Counterparty                 Financial Condition           ($ in billions)        ($ in billions)
 PMI Mortgage Insurance Co.      Run-off (managed by the
                                                                              $49.10                   $12.00
 (PMI)                           court since 8/4/11)
 Republic Mortgage Insurance     Run-off (managed by the
                                                                              $40.40                    $9.60
 Company (RMIC)                  state since 1/19/12)
 Triad Guaranty Insurance                           21
                                 Filed for bankruptcy                         $14.70                    $3.60
 Corporation (Triad)
 Genworth Mortgage Insurance
                                 Financially weakened                         $83.50                   $20.70
 Corporation (Genworth)


16
     In this case, the maximum amount of loss recovery relates to risk in force.
     Fannie Mae, “Table 45: Mortgage Insurance Coverage,” Form 10-Q for the Quarterly
     Period Ended June 30, 2013, at 72. Accessed: February 17, 2014, at
     www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2013/q22013.pdf.
     Freddie Mac, “Table 50 — Mortgage Insurance by Counterparty,” Form 10-Q for the
     Quarterly Period Ended June 30, 2013, at 83. Accessed: February 17, 2014, at
     http://api40.10kwizard.com/cgi/convert/pdf/FEDERALHOMELOANMORTGAGECORP
     -20130807-10Q-
     20130630.pdf?ipage=9066647&xml=1&quest=1&rid=23&section=1&sequence=-
     1&pdf=1&dn=1.
17
     Fannie Mae, “Risks Relating to Our Business,” Form 10-K for the Fiscal Year Ended
     December 31, 2011, at 67, 68. Accessed: February 17, 2014, at
     www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2011/10k_2011.pdf.
18
     Per Fannie Mae’s June 30, 2013 financial statements, the mortgage insurers listed as
     financially weakened were in need of capital infusions to meet the regulatory capital in
     their domicile states.
19
     Insurance in force represents the unpaid principal balance of single-family loans in the
     Enterprises’ guaranty books of business covered by the respective mortgage insurer.
20
     Risk in force is the maximum coverage on single-family loans in the Enterprises’ guaranty
     books of business and represents the maximum potential loss recoverable from the
     applicable mortgage insurer.
21
     Phil Milford, Bloomberg, Insurer Triad Guaranty Files for Bankruptcy Protection (June 4,
     2013). Accessed: March 18, 2014, at www.bloomberg.com/news/2013-06-04/insurer-
     triad-guaranty-files-for-bankruptcy-protection.html.



           Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014             9
                                                                   Insurance in Force     Risk in Force
          Counterparty               Financial Condition              ($ in billions)     ($ in billions)
 CMG Mortgage Insurance           Financially weakened -
                                                         22                     $13.80                  $3.30
 Company (CMG)                    Undergoing acquisition
 Radian Guaranty, Inc.                                        23
                                  Better financial standing                    $126.10                 $31.00
 (Radian)
 Mortgage Guaranty Insurance
                                  Better financial standing21                  $125.80                 $31.10
 Corporation (MGIC)
 United Guaranty Residential
                            24    Better financial standing                    $113.00                 $28.20
 Insurance Company (UGIC)
 Essent Guaranty, Inc. (Essent)   Better financial standing                     $19.20                  $4.60
 National Mortgage Insurance      Newly approved (January
                                                                                 $0.00                      0.00
 Corporation (National MI)        2013)
 Other                                                                           $1.00                  $0.20
 Total                                                                         $586.60                $144.30



The failure of mortgage insurers to meet contractual requirements can result in substantial risk
of loss to the Enterprises. Recent FHFA experience in efforts to mitigate this risk have included
the implementation of an array of additional safeguards in the Enterprises’ selection of and
continuing relationships with mortgage insurers. Clearly established and enforced policies,
procedures, and processes can help ensure the success of these oversight procedures.




22
     PMI and CUNA Mutual Group jointly own CMG. As of February 2013, Arch U.S.
     Mortgage Insurance, a U.S. subsidiary of the Bermuda-based Arch Capital Ltd., is
     working on an agreement to acquire all equity interest in CMG from PMI and CUNA
     Mutual Group. On January 30, 2014, Arch Capital completed the acquisition of CMG; the
     new company is Arch Mortgage Insurance Company.
     Arch Mortgage Insurance, Arch Capital Group Ltd. Announces Closing of Acquisition of
     CMG MI and PMI’s Operating Platform. Accessed: March 18, 2014, available at
     http://phx.corporate-ir.net/phoenix.zhtml?c=74599&p=irol-
     newsArticle&ID=1895458&highlight.
23
     As of December 2012, Radian and MGIC were deemed financially distressed; however, as
     per Fannie Mae’s June 2013 quarterly financial statements, Radian and MGIC were able to
     secure enough capital to meet the state’s risk-to-capital requirements and are no longer
     considered financially distressed.
24
     Per FHFA, UGIC losses were covered by agreements with its parent company (AIG) who
     received Troubled Asset Relief Program funds.



           Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014            10
2. FHFA Should Establish Criteria Defining the Review and Approval of New Mortgage
   Insurers

Although Fannie Mae rated the approval of the new mortgage insurer, National MI, as a high-
risk event, FHFA delegated approval of the new mortgage insurer to the Enterprises. This was
based upon the letter of instruction clause stating conservator approval is not required for matters
deemed to be within the Enterprises’ delegated authority.

Although the letter of instruction allows delegation of authority for the approval of new
counterparties, it also includes the following provision that requires FHFA approval: “Increases
in Board [of Directors] risk limits, material changes in accounting policy, and reasonably
foreseeable material increases in operational risk.”25 FHFA contends that their review process
was performed in conjunction with the Enterprises and was adequate to ensure all risks were
controlled, including operational risk. FHFA has not clearly defined which Enterprise activities
constitute a “reasonably foreseeable material increase in operational risk.”

Further, FHFA’s Single-Family Credit Risk Management Module states, “the failure of any
significant counterparty to meet its obligations to an enterprise could have a material adverse
effect on an enterprise’s results of operations, financial condition, and ability to conduct future
business. … A failure by an enterprise to manage exposure to financially weakened
counterparties could further increase credit risk and losses.”

Despite the initial concerns identified by the Enterprises, which resulted in the conditional
approval requirements, FHFA did not document their comprehensive evaluation to determine
whether the Enterprises’ review processes identified all potential risks or whether the conditional
approval requirements mitigated those risks.

The Enterprises may engage in transactions that increase their insurance risk exposure. For
example, FHFA’s 2013 Conservatorship Scorecard includes as Goal Two, with a 50% weight,
that “each enterprise will demonstrate the viability of multiple types of risk transfer transactions
involving single family mortgages with at least $30 billion of unpaid principal balances in
2013.”26 National MI and Fannie Mae entered into a risk-sharing transaction, which involves
over $5 billion in unpaid principal balances on single-family loans.



25
     Letter of Instruction, FHFA Office of the Director, November 15, 2012 –The letter of
     instruction defines the roles and responsibilities of the Agency, the board of directors, and
     management at the Enterprises. The first letter was provided to the Enterprises on
     November 24, 2008, and was subsequently updated and re-issued on November 15, 2012.
26
     Federal Housing Finance Agency, “Contract the Enterprises Dominant Presence in the
     Marketplace While Simplifying and Shrinking Certain Operations,” Conservatorship



            Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   11
As conservator, FHFA has the responsibility for ensuring significant Enterprise business
decisions are adequately reviewed and approved. Due to the volatile nature of the mortgage
insurance industry and financial stability concerns throughout the financial crisis, FHFA should
consider evaluating whether the risks posed to the Enterprises by mortgage insurers is significant
enough to require FHFA approval over new mortgage insurers.




 Strategic Plan: Performance Goals for 2013, at 2. Accessed: February 17, 2014, at
 http://www.fhfa.gov/AboutUs/Reports/ReportDocuments/2013EnterpriseScorecard_508.pdf.



        Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   12
CONCLUSIONS ..........................................................................

While FHFA has performed certain oversight and monitoring of mortgage insurance related
activities, there continue to be opportunities for FHFA to enhance these procedures related
to the risks posed to the Enterprises from conducting business with mortgage insurers.
Additionally, FHFA has the opportunity to ensure the non-delegated authorities, included in
the letter of instruction, are specific and encompass Enterprise activities that require FHFA
approval.




RECOMMENDATIONS ...............................................................

CohnReznick recommends that FHFA take the following actions:

   1. Establish policies, procedures, and processes to execute FHFA’s oversight of the
      Enterprises’ monitoring of business conducted with mortgage insurers. These policies
      should provide for the coordinated involvement of necessary FHFA divisions and
      define their roles and responsibilities in matters pertaining to managing risks to the
      Enterprises associated with mortgage insurers;

   2. Develop specific criteria, and update the letter of instruction accordingly, that
      classifies new mortgage insurers as non-delegated activities that require FHFA
      approval; and

   3. Develop a methodology for FHFA’s review of new mortgage insurers and ensure
      procedures performed are adequately documented and support the conclusions reached
      during the review.




        Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   13
SCOPE AND METHODOLOGY ....................................................

Scope

The period covered by CohnReznick’s audit was from September 2008 through May 2013.
CohnReznick performed fieldwork from April 2013 through January 2014 at FHFA’s offices
in Washington, DC; Fannie Mae’s headquarters in Washington, DC; and Freddie Mac’s
headquarters in McLean, Virginia.

General Methodology

To achieve its objectives, CohnReznick performed the following procedures:

       Interviewed FHFA and Enterprise personnel to gain an understanding of the oversight
        and evaluation procedures in place and of the financial condition of mortgage insurers;

       Reviewed Enterprise documentation submitted to FHFA regarding the financial condition
        of mortgage insurers;

       Reviewed FHFA examinations procedures and results, including remediation activities,
        related to the financial condition of the mortgage insurers and risk exposure to the
        Enterprises; and

       Evaluated FHFA’s activities related to interaction with state regulators for the mortgage
        insurers in run-off/receivership, mitigation of Enterprise risk exposure, and identification
        of opportunities where DPOs could be improved.

CohnReznick assessed the reliability of data received for this audit as determined necessary by
corroborating the information with other source data and considered the risk of fraud as it relates
to the audit objective.

CohnReznick assessed the internal controls related to the audit objective. Specifically,
CohnReznick evaluated the control standards that were significant to the audit objective,
including control activities and monitoring.

CohnReznick conducted this performance audit in accordance with Generally Accepted
Government Auditing Standards. Those standards require that audits be planned and performed
such that sufficient, appropriate evidence is obtained to provide a reasonable basis for the
findings and conclusions, based on the audit objective. CohnReznick believes that the evidence
obtained provides a reasonable basis for the findings and conclusions included herein, based on
the audit objectives.



         Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   14
APPENDIX A .............................................................................

OIG’s Response to FHFA’s Comments

On April 18, 2014, FHFA provided comments to a draft of this report. FHFA partially
agreed with recommendations 1 and 3 and disagreed with recommendation 2. Regarding
recommendation 1, FHFA identified responsive corrective action sufficient to resolve the
recommendation. FHFA actions regarding recommendations 2 and 3 are not sufficient to
resolve these recommendations. OIG requests that FHFA reconsider its position on
recommendations 2 and 3 and provide additional comments within 30 days of the issuance
of this report. OIG has attached FHFA’s full response as Appendix B and CohnReznick
considered it where appropriate in finalizing this report. Appendix C provides a summary
of the Agency’s response to CohnReznick’s recommendations and the status of corrective
actions.

With respect to recommendation 1, FHFA responded that it will enhance inter-divisional
coordination on issues related to Enterprise engagement with mortgage insurers through
existing forums used by FHFA’s supervision and conservatorship divisions. Specifically, by
November 15, 2014, FHFA agreed to establish processes to incorporate mortgage insurance
issues into the proceedings of existing senior-level Agency forums to ensure sharing and
review of mortgage insurance information on a regular basis. OIG considers FHFA’s response
to recommendation 1 to be sufficient to resolve the recommendation, which will remain open
until OIG reviews the new processes and proceedings.

Recommendation 2 requested that FHFA classify the use of new mortgage insurers as non-
delegated activities that require FHFA approval and that it update its letters of instruction
to the Enterprises accordingly. FHFA responded that it continues to believe that the
responsibility to assess, manage, and approve counterparties, including new mortgage
insurers, rests with the Enterprises. FHFA stated that, as conservator, it has provided the
Enterprises with broad delegated authority to conduct day-to-day operations although it
continually assesses changes that may be necessary to those delegations. FHFA further stated
that oversight and monitoring of mortgage insurers occurs throughout FHFA even though
approval authority is delegated.

In response to FHFA’s comments, OIG points out that applying to mortgage insurers the “one
size fits all” approach used in FHFA’s current delegation of counterparty approval authority
to the Enterprises does not take into consideration such key factors as: (1) the combined
financial and operational risk to both Enterprises associated with the addition of a new
mortgage insurer that could in turn be doing business on a nationwide basis with numerous



        Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   15
Enterprise sellers,27 (2) the potential for inconsistent approval conditions being required by
each Enterprise in the course of its separate approval processes for new mortgage insurers,28
and (3) possible concerns of other federal and state regulators regarding the prospective
mortgage insurer under consideration.29 Additionally, FHFA has in other instances established
thresholds for approval of certain transactions and revisited its conservator delegations to the
Enterprises to help ensure proper oversight of Enterprise operations.30

Although FHFA stated it continually assesses the need for changes in its delegated approval
authority to the Enterprises, it has not indicated a willingness to do so with regard to the
approval of new mortgage insurers. OIG does not consider approval of a new mortgage
insurer to be part of the routine day-to-day operations of the Enterprises—there are less than a
dozen mortgage insurers in business with the Enterprises and only one has been approved in
recent history. As noted in the audit report, the Enterprises’ financial exposure to mortgage
insurers is over $145 billion and some of the insurers are financially stressed. OIG considers
it important for FHFA as conservator to ensure appropriate due diligence on the part of each
Enterprise in the assessment of new mortgage insurers. However, individual Enterprise
analyses should be complemented by FHFA assessment of the risk across both Enterprises
that collectively provide well over half of the liquidity available in the secondary mortgage
market and rely on mortgage insurance to mitigate some of the associated credit risk. FHFA,
rather than each Enterprise, is best-positioned to assess the industry-wide and cross-Enterprise
risks because of its insight into both Enterprises, which remain entirely separate corporate



27
  OIG’s view is that each Enterprise individually cannot thoroughly assess the overall financial and
operational risk posed to both Enterprises collectively by the addition of a new mortgage insurer. FHFA
involvement is needed to facilitate analysis across both Enterprises of such factors as the impact of conditional
approval requirements established by the Enterprises, potential insurance in force, projected claims volume and
settlement amounts, and capital and liquidity sufficiency.
28
     As shown in the audit report, each Enterprise established different conditions in some cases.
29
  As noted in the audit report, mortgage insurers are approved and regulated by state authorities that may be in
possession of information directly related to consideration of a new mortgage insurer. Additionally, federal
banking agencies that supervise and regulate insured depository institutions perform examinations that can
identify adverse conditions regarding third-party relationships, including those with mortgage insurers that
pose risk to the institution. FHFA has worked to establish relationships with these other regulators to facilitate
information sharing.
30
   In OIG’s audit report, FHFA’s Conservator Approval Process for Fannie Mae and Freddie Mac Business
Decisions, OIG found that FHFA did not require conservator approval for various major business such as
transfers of mortgage servicing rights for over 700,000 loans and increases in counterparty risk limits
exceeding $500 billion (AUD-2012-008, September 27, 2012). Additionally, the report noted that the
Enterprises were not requesting approvals even where required, including with regard to mortgage insurance
settlements in excess of $50 million. Among other things, OIG recommended FHFA revisit its delegations of
authority to ensure significant business decisions receive conservator approval and strengthen controls in the
approval process. FHFA generally agreed with OIG’s recommendations.




             Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014                16
entities even in conservatorship.31 As a result, OIG considers FHFA’s comments to
recommendation 2 to be nonresponsive and the recommendation unresolved.

Concerning recommendation 3, FHFA cited work on the establishment of new minimum
eligibility standards for private mortgage insurers that intend to do business with the
Enterprises. FHFA stated that these standards will be made available for public comment this
summer. FHFA also stated it will remain informed of approvals of prospective mortgage
insurance entrants through Enterprise notification and FHFA review of Enterprise approvals
to ensure consistent application of the new standards.

OIG agrees that new industry standards for private mortgage insurer eligibility are needed
and that FHFA should be reviewing implementation of the new standards. However, OIG
believes additional action is necessary to develop a methodology for FHFA review of new
mortgage insurers. Such a methodology should: (1) enforce the new standards, (2) include
steps to help ensure compliance with new master policy agreements, (3) define the roles and
responsibilities of FHFA and the Enterprises in assessing prospective mortgage insurers, and
(4) provide for monitoring of mortgage insurers’ compliance, and determining the need for
remedial actions if needed.

In response to recommendation 3, FHFA indicated that it would be relying on after-the-fact
reviews of Enterprise approval decisions for mortgage insurers to ensure consistent
application of the new standards rather than also performing upfront reviews using a standard
methodology. Given the dollar magnitude of decisions regarding new mortgage insurers, OIG
considers both upfront and after-the-fact reviews to be essential components of a sound
internal control structure for these decisions. Because FHFA did not agree to develop a
methodology governing review of new mortgage insurers inclusive of documentation
requirements or propose sufficient alternative corrective actions (including estimated
completion dates), OIG considers FHFA’s comments to be nonresponsive and
recommendation 3 to be unresolved.




31
  OIG has previously reported on a general theme it has observed of FHFA as conservator deferring key
decisions to the Enterprises rather than proactively engaging in the review and approval process. In OIG’s sixth
Semiannual Report to the Congress, OIG stated that it has repeatedly found significant instances in which
FHFA, in its capacity as conservator, displayed undue deference to enterprise decision-making (October 31,
2013). OIG noted that some matters are sufficiently important to warrant greater FHFA involvement.




          Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014                 17
APPENDIX B..............................................................................

FHFA’s Comments on the Findings and Recommendations




       Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   18
Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   19
Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014   20
APPENDIX C ..............................................................................

Summary of Management’s Comments on the Recommendations

This table presents management’s response to the recommendations in the OIG report and the
status of the recommendations as of when the report was issued.

                                                          Expected                  Resolved
Rec.                                                     Completion    Monetary      Yes or        Open or
No.          Corrective Action: Taken or Planned            Date       Benefits       Noa          Closedb
       FHFA partially agreed with the establishment
       of policies, procedures, and processes to
       execute its monitoring of mortgage insurers.
       However, FHFA stated that it will enhance its
1.     existing coordination among divisions             11/15/2014       $0           Yes          Open
       responsible for mortgage insurance
       oversight. This action, in response to
       recommendation 1, can result in responsive
       action to this recommendation.
       FHFA disagreed with the revision of its letters
       of instruction to classify the approval of new
       mortgage insurers as a non-delegated
       activity. FHFA’s response did not provide
       actions that address the substance of this           Not
2                                                                         $0           No           Open
       recommendation, or propose alternative             Provided
       correction actions, with estimated
       completion dates. Therefore, OIG considers
       FHFA’s response to recommendation 2 to
       be nonresponsive and unresolved.
       FHFA partially agreed with the development
       of a methodology to review new mortgage
       insurers and ensure that procedures
       performed and conclusions reached are
       adequately documented. FHFA stated it will
       continue to review Enterprise decisions with
       regard to mortgage insurers in the context of        Not
3                                                                         $0           No           Open
       its existing practices and maintain its current    Provided
       documentation standards. As FHFA did not
       agree to develop a methodology governing
       review of new mortgage insurers inclusive of
       documentation requirements or propose
       sufficient alternative corrective actions
       (including estimated completion dates),



        Federal Housing Finance Agency Office of Inspector General • AUD-2014-013 • May 8 , 2014        21
                                                              Expected                    Resolved
Rec.                                                         Completion     Monetary       Yes or       Open or
No.          Corrective Action: Taken or Planned                Date        Benefits        Noa         Closedb
        OIG considers FHFA’s comments to be
        nonresponsive and recommendation 3 is
        unresolved.

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 amount ($0). Monetary benefits are considered resolved
as long as management provides an amount.
b
  Once 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-2014-013 • May 8 , 2014            22
ADDITIONAL INFORMATION AND COPIES .................................


For additional copies of this report:

      Call: 202–730–0880
      Fax: 202–318–0239
      Visit: www.fhfaoig.gov



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

      Call: 1–800–793–7724
      Fax: 202–318–0358
      Visit: www.fhfaoig.gov/ReportFraud
      Write:
                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-2014-013 • May 8 , 2014   23