oversight

FHFA Actions to Manage Enterprise Risks from Nonbank Servicers Specializing in Troubled Mortgages

Published by the Federal Housing Finance Agency, Office of Inspector General on 2014-07-01.

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

        Federal Housing Finance Agency
            Office of Inspector General




   FHFA Actions to Manage
    Enterprise Risks from
Nonbank Servicers Specializing in
     Troubled Mortgages




 Audit Report  AUD-2014-014  July 1, 2014
                                            July 1, 2014


TO:             Nina Nichols, Acting Deputy Director for Enterprise Regulation


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


SUBJECT:        Audit of FHFA Actions to Manage Enterprise Risks from Nonbank Servicers
                Specializing in Troubled Mortgages


Summary

Banks that traditionally service mortgage loans backed by the Federal National Mortgage
Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) (the
Enterprises) have been selling the rights to service troubled loans (e.g., delinquent or in default)
in bulk to new companies specialized to handle them. Often, the Enterprises are engaged in such
transfers to these nonbank special servicers. Nonbank special servicers currently hold
approximately $1.4 trillion in mortgage servicing rights out of a nearly $10 trillion market. The
companies’ servicing business concentrates on these labor-intensive loans, so the Enterprises
have approved such sales to limit resulting losses. However, these new servicers have less
stringent regulatory and financial requirements than banks, so, as part of a review of problems
identified with one such servicer, the Office of Inspector General (OIG) assessed the Federal
Housing Finance Agency’s (FHFA or Agency) controls to ensure the Enterprises monitor
nonbank special servicer performance and mitigate related risks.

Overall, OIG concluded that while FHFA and the Enterprises have responded well to specific
problems at nonbank special servicers, the Agency has not established a risk management
process or overall oversight framework to handle some general risks posed by nonbank special
servicers. These general risks include:

        Using short-term financing to buy servicing rights for troubled mortgage loans that
         may only begin to pay out after long-term work to resolve their difficulties. This
         practice can jeopardize the companies’ operations and also the Enterprises’ timely
         payment guarantees and reputation for loans they back; and

        Assuming responsibilities for servicing large volumes of mortgage loans that may be
         beyond what their infrastructures can handle. For example, of the 30 largest mortgage
         servicers, those that were not banks held a 17% share of the mortgage servicing
       Federal Housing Finance Agency Office of Inspector General • AUD-2014-014 • July 1, 2014
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       market at the end of 2013, up from 9% at the end of 2012, and 6% at the end of 2011.
       This rise in nonbank special servicers has been accompanied by consumer complaints,
       lawsuits, and other regulatory actions as the servicers’ workload outstrips their
       processing capacity.

As an example of such business practices putting the Enterprises’ reputation and credit at risk,
one nonbank special servicer has used short-term financing to acquire servicing rights on a large
volume of Enterprise-backed, troubled mortgage loans. The servicer, though, lacked adequate
infrastructure to handle the loans, which has led to consumer complaints and delayed payments
to the Enterprises. In addition, the servicer was operating with limited credit availability, which
increased the risk that it would not be able to fund its operations. In such a case, borrowers with
Enterprise-backed mortgages may not have their loans properly serviced.

Such risks are amplified by nonbank special servicers operating without the same standards and
regulation as banks that service mortgage loans. Specifically, the nonbank special servicers do
not have the same capital requirements as a bank, which means they are more susceptible to
economic downturns. Such downturns could substantially increase nonperforming loans that
require servicer loss mitigation while at the same time impact the ability of the servicer to
perform.

Several regulatory agencies, including FHFA, have identified some or all of these factors in
raising concerns about the spiking volume of mortgage loans acquired by nonbank special
servicers. However, the Agency has responded to issues with these servicers on a case-by-case
basis. Going forward, FHFA can further enhance its oversight through a more consistent
approach to nonbank special servicers. Therefore, OIG recommended that FHFA issue guidance
on a risk management process for nonbank special servicers and develop a comprehensive,
formal oversight framework to examine and mitigate the risks these nonbank special servicers
pose. FHFA generally agreed with OIG’s recommendations and is taking responsive action.

Background

Congress chartered Fannie Mae and Freddie Mac to provide stability and liquidity in the home
mortgage loan market. On July 30, 2008, the Housing and Economic Recovery Act of 2008
established FHFA as the Enterprises’ regulator. Among its responsibilities, the Agency oversees
their safety and soundness, supervises their support of housing finance and affordable housing
goals, and facilitates a stable and liquid mortgage market. On September 6, 2008, FHFA became
Fannie Mae’s and Freddie Mac’s conservator to help protect the Enterprises—and therefore the
wider financial market—from collapse. In this role, the Agency is charged with preserving and
conserving the Enterprises’ assets, ensuring the Enterprises’ focus on the housing mission, and
facilitating their emergence from conservatorship.

The Rise of Servicers Specializing in Troubled Loans

Fannie Mae and Freddie Mac buy mortgage loans, which they may hold as their own investments
or bundle for sale typically with guaranteed principal and interest payments. In either case, the


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Enterprises rely on other companies to service the loans, which includes collecting payments,
managing escrow accounts, and handling mortgage modifications, defaults, and foreclosures.

Historically, financial institutions, such as banks that originated loans for borrowers and sold the
loans to the Enterprises, also serviced them. In recent years, though, many large bank mortgage
lenders have sold some of their mortgage servicing rights to companies that are not banks.

Given the growth in the volume of delinquencies and defaults after the housing crisis in 2007,
these new servicers have come to specialize in acquiring troubled (i.e., nonperforming) loans.
Servicing these loans can be labor-intensive. For example, in the case of delinquent loans, the
servicer may need to contact the borrowers to learn about their financial situation, educate them
about the impact of not paying a mortgage, explain options for avoiding foreclosure such as loan
modifications and short sales, and ultimately initiate foreclosure proceedings if necessary.

Although troubled mortgage loans require more work and involve vulnerable borrowers,
companies that specialize in servicing such loans do so under less stringent capital requirements
than banks. Specifically, rules by federal banking regulators have increased the amount of capital
that federally insured depositories must hold against mortgage servicing rights under certain
circumstances.1 As such, nonbanks are not subject to these capital requirements, which raises
concern in a stressed environment as these servicers can be heavily concentrated in a single
business line.

Some banks have been willing to part with the risky, labor intensive work involved in servicing
troubled mortgage loans. As a result, mortgage servicing rights at U.S. commercial banks (and
thrifts) have declined by more than half since their peak in mid-2008, or from $84 billion to $40
billion. In turn, FHFA and the Enterprises have been supportive of banks, as evidenced by their
approvals of selling these rights to nonbank special servicers that can provide specialized support
to homeowners and thereby protect Enterprise investments.

Consequently, 9 of Fannie Mae’s top 20 servicers are not banks, and they account for 28% of the
overall group’s loan volume, or 3.6 million mortgage loans with approximately $600 billion in
unpaid principal balances. Similarly, nonbank servicers represent 7 of Freddie Mac’s top 20
servicers and account for 15% of the group’s loan volume, or 1.3 million loans with
approximately $230 billion in unpaid principal balances. For example, of the 30 largest mortgage
servicers, those that were not banks held a 17% share of the mortgage servicing market at the end
of 2013, up from 9% at the end of 2012, and 6% at the end of 2011.
1
  The Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the
Federal Deposit Insurance Corporation approved final regulatory capital rules in July 2013 to overhaul the
regulatory capital framework for the U.S. banking sector. Regulated banks are required to maintain higher capital
levels to hedge against financial crisis by increasing liquidity and decreasing leverage. As such, the final rules
require banks to hold more capital on hand for mortgage servicing rights. See Board of Governors of the Federal
Reserve System, Press Release (July 2, 2013) (online at
www.federalreserve.gov/newsevents/press/bcreg/20130702a.htm); Office of the Comptroller of the Currency, Press
Release (July 9, 2013) (online at www.occ.gov/news-issuances/news-releases/2013/nr-occ-2013-110.html); and
Federal Deposit Insurance Corporation, Press Release (July 9, 2013) (online at
fdic.gov/news/news/financial/2013/fil13031.html).


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Transferring Mortgage Servicing Rights

In order to acquire servicing rights, first the Enterprises (and in some instances, FHFA) must
approve transferring the rights to mortgage loans they own or guarantee. In general, according to
their respective servicing guides, when the Enterprises approve a transfer, they evaluate the
servicer in various areas, including:

         Overall servicing performance;

         Capacity to service the number and types of mortgage loans to be transferred;

         Delinquency ratios;

         Status of unresolved issues related to repurchase requests, claim denials, or other
          outstanding claims; and

         Financial condition.

After the Enterprises’ review, FHFA must approve transferring the right to service their
mortgage loans if the portfolio transferred exceeds 25,000 loans.

General Warning Signs of Nonbank Special Servicer Risks

As the volume of loans handled by nonbank special servicers has climbed, there have been signs
of financial and operational strain at the companies. Federal and state regulatory warnings on
rising risk, consumer complaints of shoddy servicing, and lawsuits about systemwide misconduct
have accompanied nonbank special servicers’ surging growth.

For example, the Financial Stability Oversight Council (FSOC)—established in part to identify
and respond to national, systemic financial risk—noted concern about financial institutions other
than banks using short-term funding to secure long-term assets (e.g., mortgage loans) without
appropriately managing the associated risks.2 FSOC, which includes FHFA as a voting member,
specifically mentioned servicers that have bought mortgage servicing rights from banks, but do
not have the same requirements to maintain capital to mitigate those risks. In other words, if
market conditions deteriorate, nonbank special servicers may not have the same reserves as
banks to meet those challenges and continue servicing the loans without interruption.

In addition, New York State banking regulators stopped a servicer’s plan to buy 184,000 loans
worth $39 billion from Wells Fargo because they were concerned about the acquiring servicer’s

2
  Public Law 111-203, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act),
established FSOC to identify risks to U.S. financial stability that could arise from the activities, material financial
distress, or failure of “large, interconnected bank holding companies or nonbank financial companies, or that could
arise outside the financial services marketplace[.]” 12 U.S.C. § 5322(a)(1)(A). FSOC also promotes market
discipline and responds to emerging threats to the nation’s financial system. Id. § 5322(a)(1)(B). FSOC is chaired by
the Secretary of the Treasury, and brings together federal and state financial regulators, and a Presidentially
appointed independent insurance expert. Id. § 5321(b).


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aggressive growth rate. The New York regulators have also asked another servicer for
information related to its policies, procedures, pipeline, staffing, and capacity related to servicing
right transfers because of its rapid growth accompanied by increased consumer complaints.

The Consumer Financial Protection Bureau (CFPB) has also warned about the risk of nonbank
special servicers’ expanding role.3 While these specialized servicers claim to have helped save
millions of homes from foreclosure, the CFPB has received thousands of complaints about
servicing interruptions and failures to honor loan modifications. With one nonbank special
servicer that services approximately 2.8 million residential loans as of year-end with $465 billion
in unpaid principal balances—CFPB settled a lawsuit to compensate homeowners over $2 billion
for years of systemic servicing misconduct.

Enterprise-Specific Warning Signs with Nonbank Special Servicer Risks

Both OIG and FHFA have expressed concerns about the Enterprises having servicing rights
transferred from highly regulated institutions such as banks to less regulated institutions such as
servicers specializing in troubled mortgage loans.

As detailed in OIG’s 2012 report on the transfer of troubled, Fannie Mae-backed mortgages from
Bank of America to nonbank special servicers, FHFA had raised concerns about such transfers as
early as June 2011, and the Agency’s Division of Enterprise Regulation (DER) noted a year later
that this issue remained a concern for the Enterprise.4 According to DER, the rapid growth of
nonbank servicers increased Fannie Mae’s operational risk. Given this rising risk, OIG
recommended that FHFA engage in closer oversight of Fannie Mae’s efforts to transfer mortgage
loans to nonbank special servicers.

In response, the Agency stated that it intended to ensure that Fannie Mae was adequately
managing its internal processes to mitigate the risk of these transfers. In addition, FHFA stated
that it would continue to follow up on these issues throughout the 2013 examination cycle, which
FHFA has done through various exams and supervisory actions that focused on individual
servicers and transfers.

One Enterprise’s internal audit reports have also noted a lack of controls over specialized
servicers. A January 2013 report highlighted weaknesses in the Enterprise’s monitoring of the
servicers’ capacity to handle their volume of business. The report noted that the servicers might
not be equipped to execute the Enterprise’s loss mitigation programs (e.g., offering alternatives
to foreclosure such as modifying loans to make them more affordable), which could lead to
financial losses.


3
  The Dodd-Frank Act created CFPB to “regulate the offering and provision of financial products and services under
the Federal consumer financial laws.” 12 U.S.C. § 5491(a).
4
 OIG, Evaluation of FHFA’s Oversight of Fannie Mae’s Transfer of Mortgage Servicing Rights from Bank of
America to High Touch Servicers (Sept. 18, 2012) (EVL-2012-008). Accessed April 10, 2014, at:
www.fhfaoig.gov/Content/Files/EVL-2012-008.pdf.


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In its quarterly filings with the Securities and Exchange Commission (SEC) as of June 30, 2013,
Freddie Mac noted that it continues to face challenges with respect to the performance of certain
servicers in managing seriously delinquent loans. As part of its efforts to address this issue and
mitigate credit losses, the Enterprise was facilitating the transfer of servicing from certain
underperforming servicers to other servicers that specialize in workouts of problem loans.
Freddie Mac concluded that some of these specialized servicers have grown rapidly in the last
two years and now service an increasing number of loans.5

In June 2013, FHFA stated in its Annual Report to Congress that Fannie Mae had begun
transferring large servicing assignments to rapidly growing nonbank companies that introduce a
new level of risk. FHFA noted that the Enterprise had a number of efforts underway to address
its operational shortcomings including with regard to nonbank special servicers, but these
projects would take several years to complete and the level of operational risk would remain a
concern throughout the transition. The report did not lay out actions FHFA would take regarding
the risks posed by nonbank special servicers or the servicer capacity issues to be considered in
transfers of mortgage servicing rights that were identified by both Enterprises.

Safety and Soundness Regulation

CFPB has regulatory responsibilities related to consumer protection for mortgage servicing
activities by banks and nonbanks. Additionally, the nonbank special servicers are subject to
certain state level standards and regulation. However, nonbank special servicers do not have a
prudential safety and soundness regulator at the federal level for their mortgage servicing
operations.6 In contrast, banks performing mortgage servicing are subject to safety and
soundness oversight by federal banking agencies such as the Federal Deposit Insurance


5
  Fannie Mae, in its 2013 annual SEC filings, mentions servicing transfers and a general risk that if a significant
mortgage servicer counterparty fails and its mortgage servicing obligations are not transferred to a company with the
ability and intent to fulfill all of these obligations, it could incur penalties for late payment of taxes and insurance on
the properties that secure the mortgage loans serviced by that mortgage servicer. Fannie Mae, Form 10-K for the
Fiscal Year Ended December 31, 2013, at 141 (online at www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-
results/2013/10k_2013.pdf). Similarly, Freddie Mac in its 2013 SEC filings stated that it faces the risk that the
Enterprise might not receive a sufficient price for the mortgage servicing rights or that they may be unable to find
buyers who are willing to assume the representations and warranties of the former servicer and have sufficient
capacity to service the affected mortgages. Freddie Mac concluded this option may be difficult to accomplish with
respect to larger servicers due to operational and capacity challenges of transferring a large servicing portfolio.
Freddie Mac, Form 10-K for the Fiscal Year Ended December 31, 2013, at 43 (online at
www.freddiemac.com/investors/er/pdf/10k_022714.pdf).
6
  In its 2014 Annual Report released on May 7, 2014, FSOC reported that mortgage servicing rights are increasingly
being transferred to nonbank mortgage servicing companies. FSOC stated that, while the CFPB and state regulators
have some authority over these companies, many of them are not currently subject to prudential standards such as
capital, liquidity, or risk management oversight. Further, FSOC concluded that, in many cases, mortgage investors’
ability to collect on mortgages is dependent on a single mortgage servicing company, where failure could have
significant negative consequences for market participants. FSOC recommended that, in addition to continued
monitoring, state regulators work together with CFPB and FHFA to collaborate on prudential and corporate
governance standards to strengthen nonbank servicers. See FSOC, 2014 Annual Report, at 114 (online at
www.treasury.gov/initiatives/fsoc/Documents/FSOC%202014%20Annual%20Report.pdf).


      Federal Housing Finance Agency Office of Inspector General • AUD-2014-014 • July 1, 2014
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Corporation and Office of the Comptroller of the Currency (OCC). 7 These regulators focus on
key risk components at regulated institutions including risks related to capital, assets, liquidity,
management, earnings, and market activities, as well as compliance with mortgage servicing
regulations.

The Enterprises oversee their servicing contracts with both bank and nonbank special servicers
and, in turn, FHFA regulates the Enterprises. However, in the case of nonbank special servicers,
there is not the additional regulatory regimen provided by federal banking agencies upon which
FHFA and the Enterprises can place a level of reliance in structuring their oversight.

Finding: FHFA Can Help Mitigate Nonbank Special Servicer Risk with Additional
Guidance and Oversight

FHFA has not established a risk management process or overall oversight framework to handle
some risks posed by nonbank special servicers. While FHFA identified in its Annual Report to
Congress issued in June 2013 that counterparty risk was a concern given the greater prominence
of nonbank special servicers, it approved transferring troubled loans to these servicers.8 Risks
associated with nonbank special servicers are reflected in concerns expressed by financial
regulators and in a recent case where FHFA and the Enterprises were confronted with significant
risks at a nonbank special servicer. Specifically, over the last three years, the Enterprises have
taken remedial steps to address operational deficiencies discovered at one mortgage loan servicer
specializing in troubled loans. They have identified major risks with this nonbank special
servicer’s ability to handle the volume of troubled mortgages the company has acquired, and,
accordingly, have focused monitoring resources on the company and taken or directed corrective
action. While these steps were intended to address the identified risks, FHFA has not established
a risk management process unique to nonbank special servicers to better oversee how the
Enterprises control inherent risks in transferring mortgage servicing rights and performing large
scale servicing operations. Additionally, FHFA would benefit from structuring its oversight of
these nonbank special servicers and the controls employed by the Enterprises under a formal
oversight framework. These actions are particularly important given the growth in use of
nonbank special servicers and the more limited regulatory oversight of these servicers as
compared to banks performing servicing functions.

A Case of Nonbank Special Servicer Risk

Warnings about one nonbank special servicer emerged in 2011 and 2012 when Freddie Mac
determined that the servicer warranted increased oversight because of concerns (among other
things) about how fast the company was acquiring mortgage loan servicing rights. Fannie Mae’s

7
  Federal banking agencies regulate federally-insured depository institutions. For ease of reference, this report refers
to all such institutions as “banks.”
8
  See FHFA 2012 Annual Report to Congress (June 13, 2013) (online at
http://www.fhfa.gov/AboutUs/Reports/ReportDocuments/2012_AnnualReportToCongress_508.pdf )




      Federal Housing Finance Agency Office of Inspector General • AUD-2014-014 • July 1, 2014
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overlapping concerns in 2012 and 2013 focused on this nonbank special servicer’s failure to
provide sufficient documentation to allow the Enterprise to assess its capacity to service the
loans it had or planned to acquire. For example, this nonbank special servicer bought the right to
service large amounts of mortgage loans from several banks. Additionally, the servicer already
had billions of dollars in servicing right acquisitions in its pipeline. FHFA approved these large
transfers of Enterprise loan servicing under the condition of increased Enterprise surveillance
and review of this company’s servicing operations given its considerable growth.

Despite being subjected to increased oversight, this nonbank special servicer’s infrastructure
proved insufficient to properly service some Enterprise-backed mortgage loans. Freddie Mac
became aware of operational problems initially because of Enterprise-backed loans for which
there were remittance delays. The Enterprise notified FHFA, which in turn alerted Fannie Mae.
Both Enterprises separately sent their respective review teams to this servicer and found
operational risks related to weak infrastructure such as poor practices for handling borrower
complaints.

Fannie Mae found the servicer had breached the Enterprise’s minimum capital requirements.
According to Fannie Mae’s servicing guide, this violation constituted a breach of contract and
presented an unacceptable risk to the Enterprise. Failure by the company to resolve this issue
could result in a suspension of the contract, meaning Fannie Mae would cease all commitments
on loan purchases and the servicer would not be able to service any more of the Enterprise’s
loans.

Subsequently, Freddie Mac suspended any further bulk sales of servicing rights to this company.
Fannie Mae then informed the company in early 2013 that it would not approve material
transfers until the company met certain requirements. In January 2014, at FHFA’s request,
Fannie Mae detailed actions the servicer must take to address operational issues. Also at the
Agency’s request, Freddie Mac required similar remediation from the servicer.

For its part, FHFA had previously identified the potential for this nonbank special servicer to
encounter liquidity problems given the servicer’s reliance on short-term debt (borrowing) to pay
for long-term assets (servicing). FHFA concluded that the company’s current problems resulted
from inadequate operations and a weak infrastructure. In part to address liquidity concerns, the
servicer subsequently sold some mortgage servicing rights to other companies.

Opportunity to Mitigate Specialized Servicer Risks

FHFA and the Enterprises have worked to mitigate the specific problems identified with the
nonbank special servicer discussed above. The roots of those problems, though, are shared by
other nonbank special servicers that have rapidly bought large volumes of mortgage loan
servicing rights, including where short-term financing is used, which can strain their operations
and finances. Since the Enterprises back these loans, such strains can increase credit risk. In
addition, poor or interrupted servicing—particularly for vulnerable homeowners with troubled
mortgage loans—can risk the Enterprises’ reputation.



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As discussed, the FSOC, CFPB, federal and state banking regulators, and FHFA have noted the
escalating risks posed by the rapid rise of nonbank special servicers taking over servicing from
traditional financial institutions such as banks. The case with the nonbank special servicer
discussed above highlights FHFA’s opportunity to implement a formal, comprehensive plan to
supervise Enterprise oversight of nonbank special servicers and take advantage of the lessons
already learned in assessing FHFA and Enterprise controls.

FHFA’s regulatory peers have been active in issuing mortgage servicing guidance relevant to the
rising risk posed by nonbank special servicers. Such directives can serve as examples of best
practices for FHFA to consult in formulating its own guidance. For example:

          In February 2013, the CFPB issued guidance to residential mortgage servicers to
           address potential risks to consumers that may arise in connection with transfers of
           servicing.9 As appropriate, the CFPB will require servicers engaged in significant
           servicing transfers to submit written plans detailing how they will manage the
           associated consumer risks. The CFPB will use the plans to assess consumer risks and
           inform its examination planning.

          In October 2013, OCC published risk management guidance for assessing and
           managing risks associated with third-party relationships. 10 A third-party relationship
           is defined as any business arrangement between a bank and another entity, by contract
           or otherwise. This guidance provides a framework for managing third-party risk that
           could be applied by FHFA to Enterprise oversight of nonbank special servicers that
           perform servicing functions on contract with the Enterprises. Specifically, the OCC
           guidance calls for a risk management process throughout the life cycle of the
           relationship including:

              o Plans that outline the bank’s strategy, identify the inherent risks of the activity,
                and detail how the bank selects, assesses, and oversees the third party.

              o Proper due diligence in selecting a third party.

              o Written contracts that outline the rights and responsibilities of all parties.

              o Ongoing monitoring of the third party’s activities and performance.

              o Contingency plans for terminating the relationship in an effective manner.

              o Clear roles and responsibilities for overseeing and managing the relationship
                and risk management process.
9
  CFPB Bulletin 2013-01 – Mortgage Servicing Transfers (February 11, 2013) (online at
files.consumerfinance.gov/f/201302_cfpb_bulletin-on-servicing-transfers.pdf).
10
   OCC is the primary federal regulator for national banks and federal savings associations. OCC Bulletin 2013-29 –
Third Party Relationships: Risk Management Guidance (October 30, 2013) (online at occ.gov/news-
issuances/bulletins/2013/bulletin-2013-29.html).


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            o Documentation and reporting that facilitates oversight, accountability,
              monitoring, and risk management.

            o Independent reviews of third party activities.

As the Enterprises’ conservator, FHFA is positioned to confront nonbank special servicer risks
that it and its partner agencies have identified by directing the Enterprises to identify and
mitigate those risks through a formal risk management process. Additionally, FHFA would
benefit from a formal, comprehensive, supervision and examination framework for Enterprise
oversight of contracts with nonbank special servicers—steps that can help FHFA better protect
both the Enterprises and borrowers. Additional Enterprise controls and FHFA oversight are
important since these nonbank special servicers do not have a dedicated federal regulator similar
to banks that perform servicing.

Recommendations

OIG recommends that FHFA:

   1. Issue guidance to the Enterprises on the risk management process that should be
      employed to identify and mitigate risks related to nonperformance under Enterprise
      contracts with nonbank special servicers.

   2. Develop a comprehensive, formal framework to mitigate the risks nonbank special
      servicers pose to the Enterprises that includes routine FHFA examinations, Enterprise
      reviews, and capacity testing before acquisition of servicing rights to ensure these
      servicers can continue to fulfill their servicing requirements.

FHFA provided comments (see Attachment A) generally agreeing with OIG’s recommendations.
Attachments B and C contain OIG’s evaluation of FHFA’s comments.

Objective, Scope, and Methodology

The overall objective of this performance audit was to assess FHFA’s controls to ensure the
Enterprises monitor nonbank special servicer performance and mitigate related risks. To
accomplish this objective, in part, OIG reviewed FHFA’s response to concerns raised with one
nonbank special servicer that experienced operational issues. During the course of OIG’s audit,
those concerns raised more comprehensive issues related to FHFA’s general risk management
approach to nonbank special servicers and related internal control.

OIG conducted its fieldwork at FHFA’s headquarters and Fannie Mae’s corporate office in
Washington, DC, and Freddie Mac’s corporate offices in McLean, VA.

In order to accomplish its objective, OIG:

        Interviewed Fannie Mae and Freddie Mac Single-Family Business Unit and Enterprise
         Risk Management personnel; specifically, the Enterprise staff responsible for


       Federal Housing Finance Agency Office of Inspector General • AUD-2014-014 • July 1, 2014
                                                 10
            servicers’ performance reviews, oversight and remediation, and counterparty credit
            risk management and oversight;

           Obtained information from FHFA staff in the divisions of Enterprise Regulation, and
            Housing Mission and Goals about the Agency’s oversight, supervision, and guidance
            of servicers;

           Reviewed the past two years of the nonbank special servicer’s counterparty credit risk
            evaluation and servicer performance reviews, including remediation, corrective action,
            and escalation from the Enterprises;

           Discussed with FHFA and the Enterprises their servicer review and validation process;

           Discussed potential fraud issues and/or complaints with the Enterprises and FHFA;

           Assessed internal control within FHFA’s oversight process; and

           Interviewed the Enterprises’ internal audit staff about the Enterprises’ respective
            processes for reviewing servicer performance.

OIG conducted fieldwork for this performance audit from November 2013 through April 2014
in accordance with generally accepted government auditing standards. Those standards require
that OIG plan and perform audits to obtain sufficient, appropriate evidence to provide a
reasonable basis for the findings and conclusions based on the audit objective. OIG believes that
the evidence obtained provides a reasonable basis for the finding and conclusions included
herein, based on the audit objective.

OIG appreciates the cooperation of everyone who contributed to this audit, including officials at
FHFA, Fannie Mae, and Freddie Mac. This audit was led by Kevin Carson, Audit Director, who
was assisted by Damon Jackson, Audit Manager, and Crystal Tsang, Senior Auditor.


cc:         Melvin L. Watt, Director
            Eric Stein, Acting Chief Operating Officer
            Sandra Thompson, Deputy Director for Housing Mission and Goals
            Robert Ryan, Special Advisor
            Mark Kinsey, Chief Financial Officer
            John Major, Internal Controls and Audit Follow-up Manager

Appendices:        Appendix A: FHFA’s Comments on OIG’s Findings and Recommendations
                   Appendix B: OIG’s Response to FHFA’s Comments
                   Appendix C: Summary of FHFA’s Comments on the Recommendations




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Appendix A

FHFA’s Comments on OIG’s Findings and Recommendations




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Appendix B

OIG’s Response to FHFA’s Comments

On June 10, 2014, FHFA provided comments to a draft of this report, generally agreeing with
OIG’s recommendations and identifying specific actions it would take to address the
recommendations. With respect to Recommendation 1, FHFA stated that the Agency is in the
process of developing additional supervisory guidance on counterparty risk management that
will set forth supervisory expectations for how the Enterprises manage risks associated with
servicing of troubled loans, including by nonbank special servicers. This guidance will be issued
by December 1, 2014. OIG considers FHFA’s response to Recommendation 1 to be sufficient to
resolve the recommendation, which will remain open until OIG receives and reviews the
guidance.

FHFA partially agreed with Recommendation 2. Recommendation 2 requested that FHFA
develop a comprehensive, formal framework to mitigate the risks nonbank special servicers pose
to the Enterprises. In response, FHFA stated that it does not agree that FHFA’s supervision
function should develop a framework for mitigating risk to the Enterprises and that the
Enterprises are responsible for developing policies and procedures for mitigating risks posed by
counterparties, including servicers. However, the policies and procedures should be developed
and implemented consistent with supervisory expectations for safe and sound operation. FHFA
stated that it would carefully assess the policies and procedures and their implementation by each
Enterprise. FHFA examination work in the 2014 Supervisory Plans will assess each Enterprise’s
identification and management of risks posed by nonbank special servicers. This examination
work will be documented by April 30, 2015.

In addition to these proposed actions for Recommendation 2, FHFA stated that it would issue
guidance describing supervisory expectations for the Enterprises’ risk management for mortgage
servicing transfers. On June 11, 2014, FHFA issued Advisory Bulletin, 2014-06, Mortgage
Servicing Transfers. The bulletin communicates supervisory expectations for risk management
practices in conjunction with the sale and transfer of mortgage servicing rights or the transfer of
the operational responsibilities of servicing mortgage loans owned or guaranteed by the
Enterprises. Consistent with OIG’s recommendation, the bulletin requires consideration of
servicer capacity, including staffing, facilities, information technology systems, and any sub-
servicing arrangements, as part of the analysis of mortgage servicing transfers. OIG commends
FHFA for attention to this matter. OIG considers the actions already taken or planned sufficient
to resolve Recommendation 2. The recommendation will remain open until OIG determines that
the agreed-upon actions are completed.

OIG considered the Agency’s full response (attached as Appendix A) in finalizing this report.
Appendix C provides a summary of management’s comments on the recommendations and the
status of agreed-upon actions.




     Federal Housing Finance Agency Office of Inspector General • AUD-2014-014 • July 1, 2014
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Appendix C

Summary of FHFA’s Comments on the Recommendations

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


                                                    Expected         Monetary
 Rec.          Corrective Action: Taken or         Completion         Benefits      Resolved:       Open or
 No.                     Planned                      Date          ($ Millions)    Yes or No a     Closed b
1.        FHFA will develop additional            December 1,           $0             Yes           Open
          supervisory guidance on how the         2014
          Enterprises manage risks associated
          with servicing troubled loans,
          including by nonbank special
          servicers.
2.        FHFA examination work in the 2014       April 30,              $0             Yes           Open
          Supervisory Plan will assess each       2015
          Enterprise’s identification and
          management of risks posed by
          nonbank special servicers.

a
 Resolved means: (1) Management concurs with the recommendation, and the planned, ongoing, and 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 the agreed-upon corrective actions have been completed and are responsive, the
recommendations can be closed.




        Federal Housing Finance Agency Office of Inspector General • AUD-2014-014 • July 1, 2014
                                                       15
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-2014-014 • July 1, 2014
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