oversight

FHFA's Representation and Warranty Framework

Published by the Federal Housing Finance Agency, Office of Inspector General on 2014-09-17.

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

          Federal Housing Finance Agency
              Office of Inspector General




FHFA’s Representation and Warranty
           Framework




Audit Report  AUD-2014-016  September 17, 2014
                FHFA’s Representation and Warranty Framework

                Why OIG Did This Report
                In June 2011, FHFA initiated the Contract Harmonization Project to improve
                the Enterprises’ contracts and contracting processes with seller-servicers to
                maximize seller-servicer performance and, thus, economic return on the
                Enterprises’ loan portfolios. The new representation and warranty framework
  At A          is a component of the Contract Harmonization Project that FHFA prioritized
                and was implemented in September 2012. The framework’s objective is to
 Glance         clarify seller repurchase exposure and liability on future loans sold to the
   ———          Enterprises.

September 17,   The new framework relieves sellers from certain representations and
    2014        warranties, such as those relating to credit underwriting and eligibility of the
                borrower and property that were formerly effective for the life of the loan.
                Under the new framework, repurchase relief is granted to sellers if loans
                acquired by the Enterprises on or after January 1, 2013, meet specific
                acceptable payment history criteria of 12, 36, or 60 months, depending on the
                loan product and when it was acquired.

                The financial magnitude of FHFA’s mandated changes to the framework
                represents a sea-change to the Enterprises’ risk management programs and
                quality control processes. The financial magnitude is based on the Enterprises’
                level of single family business following the implementation of the new
                framework. For example, in 2013, the first year for the new framework, the
                Enterprises bought approximately 5.6 million loans from sellers with a total
                unpaid principal balance exceeding $1.13 trillion.

                Before these changes, the Enterprises’ risk management model primarily relied
                on reviewing loans for underwriting deficiencies after they defaulted as the
                representations and warranties were effective for the life of the loans. In
                contrast, the new framework transfers responsibility to the Enterprises to
                review loans upfront for eligible representation and warranty deficiencies
                that may trigger repurchase requests. If the Enterprises fail to do so within the
                applicable period, their ability to pursue a repurchase request expires if it is
                based upon a representation and warranty that qualifies for repurchase relief.

                Given this elevated risk from the new framework and the financial magnitude
                of loans involved, FHFA’s Office of Inspector General (OIG) audited FHFA’s
                oversight of the Enterprises’ implementation of the new representation and
                warranty framework.
                What OIG Found
                OIG found that FHFA mandated a new framework despite significant
                unresolved operational risks to the Enterprises. Neither Enterprise had
                implemented the processes, procedures, and systems needed to operate within
                the new framework before it went into effect in 2013.

                Freddie Mac completed a risk analysis in August 2012 that identified two
  At A          systems that it would need to create, in addition to enhancing multiple existing
                systems, in order to support the new framework by tracking loan level data,
 Glance         and allowing sellers to receive feedback on mortgage risk and appraisal quality
                prior to loan delivery. Freddie Mac estimated that full functionality of two of
   ———
                these systems was expected to be delivered over two years.
September 17,
                Likewise, Fannie Mae needed to implement or enhance numerous systems
    2014
                to support the new framework and, as of July 2014, is still in the process of
                enhancing some of those systems. Completion and full roll-out for certain
                systems are projected to occur in late 2015. As a result, there is an inherent risk
                for potential errors and the Enterprises may experience credit losses that
                otherwise may have been mitigated through use of contractual remedies such
                as repurchases.

                OIG also found that FHFA mandated a 36-month sunset period for
                representation and warranty relief without validating the Enterprises’ analysis
                or performing sufficient additional analysis to determine whether financial
                risks were appropriately balanced between the Enterprises and sellers. Freddie
                Mac, in contrast to Fannie Mae which provided analysis limited to a 36-month
                period, provided FHFA with the results of an internal analysis of loans that
                indicated loans with a 48-month clean payment history were significantly less
                likely to exhibit repurchaseable defects than loans with a 36-month clean
                payment history. Thus, losses to the Enterprise could be less with a longer
                sunset period. Therefore, FHFA cannot support that the sunset period selected
                does not unduly benefit sellers at the Enterprises’ expense.

                What OIG Recommends
                OIG recommends that: (1) FHFA assess whether the Enterprises’ current
                operational capabilities minimize financial risk that may result from the new
                framework and (2) FHFA assess whether the financial risks associated with the
                new framework, including the sunset periods, are balanced between the
                Enterprises and the sellers. FHFA provided responsive comments to the first
                recommendation, but not the second. OIG requests FHFA to reconsider its
                disagreement with the second recommendation.
TABLE OF CONTENTS ................................................................
AT A GLANCE ...............................................................................................................................2

ABBREVIATIONS .........................................................................................................................6

PREFACE ........................................................................................................................................7

CONTEXT .......................................................................................................................................8
      FHFA Directed the Enterprises to Work with the Agency on Contract Harmonization
      and Prioritize Work on the Representation and Warranty Framework ....................................8
      The Enterprises and FHFA Developed the New Representation and Warranty
      Framework ................................................................................................................................9
      FHFA’s Directive Implementing the New Representation and Warranty Framework ..........12
      FHFA Modifications to the New Representation and Warranty Framework .........................15

FINDINGS .....................................................................................................................................18
      1. FHFA Mandated a New Representation and Warranty Framework Despite
         Significant Unresolved Operational Risks to the Enterprises ............................................18
              Enterprise System Enhancements ...................................................................................18
              FHFA Examination Coverage ........................................................................................21
      2. FHFA Mandated a 36-Month Sunset Period for Representation and Warranty
         Relief Without Validating the Enterprises’ Analyses or Performing Sufficient
         Analysis Needed to Appropriately Balance Financial Risk Between the
         Enterprises and Sellers .......................................................................................................23
              Enterprise Analyses ........................................................................................................23
              FHFA Independent Validation........................................................................................25

CONCLUSION ..............................................................................................................................27

RECOMMENDATIONS ...............................................................................................................28

OBJECTIVES, SCOPE, AND METHODOLOGY .......................................................................29

APPENDIX A ................................................................................................................................31
      FHFA’s Comments on OIG’s Findings and Recommendations ............................................31



                                        OIG  AUD-2014-016  September 17, 2014                                                                4
APPENDIX B ................................................................................................................................34
      OIG’s Response to FHFA’s Comments .................................................................................34

APPENDIX C ................................................................................................................................36
      Summary of FHFA’s Comments on the Recommendations ..................................................36

ADDITIONAL INFORMATION AND COPIES .........................................................................37




                                       OIG  AUD-2014-016  September 17, 2014                                                              5
ABBREVIATIONS .......................................................................

ADVS                  Appraisal Data Validation System

AUM                   Appraisal and Underwriting Model

AUS                   Automated Underwriting Systems

CU                    Collateral Underwriter

DER                   FHFA’s Division of Enterprise Regulation

Enterprises           Fannie Mae and Freddie Mac

Fannie Mae            Federal National Mortgage Association

FHFA or Agency        Federal Housing Finance Agency

Framework             Representation and Warranty Framework

Freddie Mac           Federal Home Loan Mortgage Corporation

IRWTS                 Internal Representation and Warranty Tracking System

LQA                   Loan Quality Advisor

NUC                   Fannie Mae’s National Underwriting Center

OHRP                  FHFA’s Office of Housing and Regulatory Policy

OIG                   Federal Housing Finance Agency, Office of Inspector General

QAS                   Quality Assurance System

RDW                   Relational Data Warehouse

UCDP                  Uniform Collateral Data Portal




                        OIG  AUD-2014-016  September 17, 2014                     6
PREFACE ...................................................................................

OIG was established by the Housing and Economic Recovery Act of 2008. OIG is authorized
to conduct audits, evaluations, investigations, and other law enforcement activities pertaining
to FHFA’s programs and operations. As a result of its work, OIG may recommend policies
that promote economy and efficiency in administering FHFA’s programs and operations, or
that prevent and detect fraud and abuse in them.

Given the array of risks associated with FHFA’s mandated new representation and warranty
framework, this audit report is part of OIG’s proactive audit and evaluation strategy to assess
the Agency’s related oversight and conservatorship efforts. One aspect of this strategy focuses
on FHFA’s oversight of the Enterprises’ operations under the new framework to ensure they
function safely and soundly, and that they appropriately manage associated operational and
financial risks.

OIG appreciates the cooperation of all those who contributed to this audit, including officials
at FHFA, Fannie Mae, and Freddie Mac. This audit was led by Laura Benton, Audit Director,
and Scott H. Smith, Audit Manager, who were assisted by Christopher Sim, Auditor-in
Charge.

This audit report has been distributed to Congress, the Office of Management and Budget, and
others, and will be posted on OIG’s website, www.fhfaoig.gov.




Russell A. Rau
Deputy Inspector General for Audits




                           OIG  AUD-2014-016  September 17, 2014                                7
CONTEXT ..................................................................................

In June 2011, FHFA informed the Enterprises that the contracts employed by the Enterprises
with their seller-servicers might benefit from harmonization, affording a stronger position for
the Enterprises in light of deficiencies in the servicing and delivery process.1 FHFA undertook
a priority project to identify areas that would improve the Enterprises’ contracts and
contracting process with seller-servicers to ensure they reflected viable business relationships
that were actively managed to maximize seller-servicer and portfolio performance and
economic return to the Enterprises.

FHFA Directed the Enterprises to Work with the Agency on Contract Harmonization
and Prioritize Work on the Representation and Warranty Framework

Through their contractual agreements with the Enterprises, sellers represent and warrant that
the mortgages sold to the Enterprises comply in all respects with the standards outlined in
Fannie Mae’s Selling Guide and lender contracts and Freddie Mac’s purchase documents,
including underwriting and documentation standards. Seller representations and warranties
generally relate to the underwriting of the borrower, the mortgaged premises and the project
in which the mortgaged premises is located. If a mortgage is not compliant, the Enterprises
may exercise their respective contractual remedies, including the issuance of a repurchase
request. The Enterprises’ ability to require sellers to repurchase loans is necessary to
minimize losses that can be caused by underwriting defects, which ultimately represent losses
to U.S. taxpayers.

As a result of dialogue between FHFA and the Enterprises regarding possible areas of
contract consistency, the Agency determined that contract harmonization was necessary and
appropriate in eight areas. On January 19, 2012, FHFA directed the Enterprises to work with
it to align their contracts in eight areas. FHFA identified two areas as top priorities to
implement within 180 days: (1) “Consistent and precise benchmarks and measureable
standards for repurchase requests and other penalties for nonperformance,” and (2) “consistent
timelines and collection standards for fees and penalties and additional types of penalties and
remedies.”2 The first top priority area of the directive initiated the process of changing the
Enterprises’ representation and warranty framework.

1
 Seller-servicers are financial entities organized under federal or state jurisdiction that are eligible to sell
mortgages to the Enterprises and to service mortgages purchased by the Enterprises.
2
  Repurchase of a loan by a seller is a contractual remedy available to the Enterprises for breaches of the
representations and warranties concerning loan eligibility made at the time of sale to the Enterprises.




                                   OIG  AUD-2014-016  September 17, 2014                                         8
Under the new framework, relief was granted for representations and warranties relating to
the credit underwriting or eligibility of the borrower and the property, including its value,
once the loan met specific eligibility criteria. Under the new framework, a sunset period is
the required number of months that pass with acceptable pay history following the acquisition
of a loan that qualifies sellers for representation and warranty relief. The new framework
excluded repurchase relief for certain representations and warranties that remain in effect for
the life of the loan, such as misstatements, misrepresentations, omissions, charter violations,3
and noncompliance with state, federal, and local laws and regulations.

The Enterprises and FHFA Developed the New Representation and Warranty
Framework

In response to FHFA requests to prioritize work on the new framework, the Enterprises began
providing information and data to FHFA for its consideration in formulating the terms of the
new framework. Between February 2012 and May 2012, the Enterprises provided proposals
for the new framework and studies concerning the sunset period. During this timeframe,
FHFA conducted meetings with large, medium, and small sellers to develop an understanding
of their experiences with repurchases and to discuss possible enhancements to the
representation and warranty model.4

In preparation for a new framework, Freddie Mac also completed a risk analysis and issued
a memorandum on May 11, 2012, detailing the results of its review. The risk analysis
concluded that the new framework was a fundamental change in its single-family business
practices and might increase the company’s overall risk profile.5 This memorandum explained
3
  Sellers are responsible for representations and warranties for the life of the loan for compliance with the
Enterprises’ charters. In accordance with their charter requirements, a mortgage loan (or any participation
interest therein) must meet all of the following requirements to be eligible for sale to the Enterprises: be
secured by property that is residential in nature; be secured by a property located within a U.S. state, the
District of Columbia, or any U.S. territory or possession; be secured by a property with four or fewer units,
unless sold through Fannie Mae’s multifamily mortgage business; have an original principal balance not
greater than the applicable maximum loan limit in effect at the time of Fannie Mae’s acquisition; and have a
loan-to-value ratio of 80% or less of the security property’s value at the time Fannie Mae acquires the loan, or
if the mortgage has a loan-to-value ratio in excess of 80%, the mortgage must meet specific criteria.
4
 The feedback FHFA received from sellers included the following: support for a sunset period ranging from
24 to 48 months, a phase-in of the sunset period to allow sellers to incorporate new rules into their systems
and operations, and performance of quality control within a defined window after delivery of the loan (e.g.,
6 months) as defects are easier to cure if identified earlier in the process.
5
  Freddie Mac prepared a final risk analysis memo dated August 23, 2012, to supplement its initial risk
analysis. According to this final risk analysis, Freddie Mac believed that the key risks identified in the risk
analysis memorandum dated May 11, 2012, were still valid and that no significant new risks were discovered.
Additional detail regarding some of the previously identified risks was provided, but did not supersede any of
the original key risks.




                                 OIG  AUD-2014-016  September 17, 2014                                           9
that because the changes to the framework will be mandated by FHFA, Freddie Mac’s ability
to maintain its franchise value and minimize risk associated with the proposed framework was
limited. Further, the aggressive timelines associated with the significant business changes
impacted Freddie Mac’s ability to consider and propose alternatives and also elevated the risk
of implementation errors.

According to Freddie Mac’s risk analysis, its initial credit risk may be lower because
additional pre-funding and post-funding risk assessments may be performed, and the scope of
quality control sampling and review for performing and non-performing loans will expand,
potentially resulting in more repurchases. However, after the to-be-determined sunset date,
any credit risk on eligible loans that is related to selling representations and warranties will be
transferred from the seller to Freddie Mac. Thus, the Enterprise’s credit risk would increase as
loans moved past the sunset date. Freddie Mac concluded that accurate identification of loan
level sunset eligibility, the seller representation and warranty holder at any given time, and the
sunset date are critical to monitoring credit risk and accurately enforcing quality control
sampling, remedies, and repurchases. Yet, building out the systems to perform these tasks
would take time.

Freddie Mac’s risk analysis also identified a number of significant operational risks that
resulted from the breadth of the proposed changes to the framework and an aggressive
implementation timeline in the areas of people, processes and procedures, and
technology/systems as follows:

      People: This effort will require multiple resources across the company to support the
       system, policy, and model changes. The aggressive timelines and competing priorities
       may create stress on existing resources and increase the likelihood of implementation
       errors. It is likely that additional resources, such as full-time employees to support
       increased quality control activity, will be necessary to build and support the new
       infrastructure.

      Processes and Procedures: Numerous processes and procedures must be updated or
       developed to support the initiative. Various reporting processes across the company
       will need to be adjusted and modified to capture new data and accommodate new data
       sources.

      Technology/Systems: Numerous systems across Freddie Mac must be built,
       modified, or enhanced to support the concept of a sunset period for certain selling
       representations and warranties. Various applications must be able to identify the
       appropriate selling representation and warranty holder of a loan on a historical and
       prospective view. Six major systems have been identified that require enhancements to



                            OIG  AUD-2014-016  September 17, 2014                                   10
       accommodate new data or new source systems. Two systems will need to be built: an
       eligibility assessment tool, and a new representation and warranty tracking system.
       The implementation of this project will require a high level of effort and coordination
       among various groups in the organization to minimize or avoid any systemic operation
       deficiencies.

Fannie Mae did not prepare a similar risk analysis. However, Fannie Mae’s Internal Audit
completed a pre-implementation review of the new framework and issued its findings on
January 2, 2013, one day after the new framework became effective. Internal Audit identified
fifteen individual work streams that were related to developing policies consistent with
FHFA’s directive and communicating the new approach to sellers, refining existing defect
definitions and actions for findings, and developing new analytical tools to identify and select
a statistically valid sample population. These work streams included fielding Collateral
Underwriter (CU) and the Appraisal and Underwriting Model (AUM), and updating the
National Underwriting Center (NUC) loan review processes and its supporting Quality
Assurance System (QAS).

Most notably, Internal Audit found that although there appears to be a clear definition of the
objectives of the work streams, there did not seem to a be a formally documented, integrated
vision for the Enterprise on how the redesigned processes and systems will operate in the
future, or how other stakeholders in the Enterprise may be affected by the change. Internal
Audit concluded that until Fannie Mae management can clearly articulate the Enterprise-wide
impacts of the new framework, the full scope of efforts needed to implement the change and
effectively manage the associated risks will not be known. Internal Audit also concluded that
risk related to the implementation of the framework, such as inadequate loan selection
methodology, loan review training, vendor reporting, and system updates, would not be
mitigated until after the January 1, 2013, effective date for the new framework.

On July 1, 2013, Fannie Mae’s Internal Audit completed follow-up on the January 2013 pre-
implementation review of the new representation and warranty framework. The objective of
the follow-up review was to evaluate operational readiness of the new processes and related
controls supporting the new framework, and to assess pre-implementation controls over the
new technology and models. As part of the review, Fannie Mae’s Internal Audit looked at the
governance and design for CU and AUM, as well as change management controls over QAS
upgrades. Internal Audit found that significant progress had been made related to modeling
and tools to support the framework; however, they noted that significant model and
application updates were planned, and key resources and tools needed to support the new
framework were not fully online. Additionally, while Internal Audit did not test the new




                            OIG  AUD-2014-016  September 17, 2014                                11
models or output from the new applications or the efficacy of controls to support the
framework, it identified two control issues for management’s attention.6

       The Fannie Mae CU application entered production without a completed review by
        Model Review & Oversight.

       Segregation of duties controls between development, configuration management, and
        production execution were not adequate for the Fannie Mae AUM Analytics.

FHFA’s Directive Implementing the New Representation and Warranty Framework

FHFA reviewed the proposals, studies, and risk analyses provided by the Enterprises and
moved forward with its plans to announce a new framework in September 2012.

With regard to a sunset period, Fannie Mae submitted data and analysis to FHFA supporting
a 36-month sunset period that did not include any other alternative sunset periods for
comparative purposes. Freddie Mac submitted data and analysis supporting a 48-month
sunset period and compared sunset periods of 36 and 48 months. FHFA’s Office of Housing
and Regulatory Policy (OHRP) acknowledged that the 48-month sunset period inherently
posed less risk to the Enterprises than a 36-month sunset period, but decided to place more
importance on Fannie Mae data that it believed showed a surprisingly low percentage of
underwriting findings and defects for loans that achieved 36 months of on-time payments and
subsequently defaulted. Therefore, OHRP did not conduct further analysis of Freddie Mac’s
proposed 48-month sunset period.

OHRP also solely relied on the representations and data supplied by the Enterprises to
inform its decision on the sunset period. For example, OHRP did not independently study
the risks associated with each sunset period or ensure the data and analysis submitted by the
Enterprises was validated. OHRP also did not elicit the involvement of other FHFA offices or
procure outside expertise to help analyze or validate Enterprise data.

OHRP explained that Freddie Mac recommended a 48-month sunset period because it had not
made a decision on what tools it was going to use to leverage electronic appraisal and loan
delivery information that it was receiving. To address this concern, FHFA asked Fannie Mae
to conduct a demonstration of CU for Freddie Mac so it could consider using the same

6
  Fannie Mae’s management has addressed these two control issues. Internal Audit has verified the segregation
of duties between development, configuration management, and production activities for AUM analytics and
closed this issue. Internal Audit is expected to complete its review of management actions resulting from the
review of CU by December 2014.




                                OIG  AUD-2014-016  September 17, 2014                                         12
system. CU, however, was only in the initial implementation stage.7 Ultimately, Freddie Mac
opted to use another tool after some preliminary testing. Despite acknowledging Freddie
Mac’s concerns over the readiness of its systems, OHRP continued to implement the new
framework and told OIG that it believed the Enterprises had the necessary data and
information to identify loan defects sooner in the process.

OHRP then compiled a concept approval request recommending a new framework to FHFA’s
Acting Director. A draft term sheet dated May 24, 2012, was included within the concept
approval materials. The new framework received approval from FHFA’s Acting Director on
June 5, 2012. Following this approval, on June 8, 2012, FHFA directed the Enterprises to
implement the new framework as defined within a term sheet that included the following
broad categories:

        Selling Representation and Warranty Relief

        Loan Level Eligibility Criteria

        Automatic Repurchase Triggers

        Exclusions from Representation and Warranty Relief

        Repurchase Timelines and Remedies

        Additional Requirements and Controls (Pre- and Post-Funding Quality Control and
         Due Diligence)

The sunset period defined within the “Loan Level Eligibility Criteria” section of the term
sheet was 36 months of consecutive on-time payments or 60 months if the loan was current
on the 60th month, provided there were no more than two 30-day delinquencies in the first
36 months. OHRP explained that FHFA’s then Acting Director and other senior executives
were briefed in June 2012 and several key decisions were made, including the decision for
this sunset period. Also, the term sheet included a section entitled, “Additional Requirements
and Controls (Pre and Post Funding Quality Control and Due Diligence)” that required the use
of automated underwriting systems (AUS) or risk assessment tools approved or used by each
Enterprise before and after loan delivery, delivery of Uniform Loan Delivery Dataset (ULDD)
data and electronic appraisals, collateral valuation checks, enhanced performing loan

7
 Fannie Mae’s CU system for underwriting collateral is not broadly available. It is currently used by six seller-
servicers. Two seller-servicers began using it in September 2012, one in November 2012, and the other three
between March 2014 and May 2014. According to Fannie Mae, this system tool is being upgraded to begin a
broader industry roll out.




                                 OIG  AUD-2014-016  September 17, 2014                                            13
sampling, and continued sampling of non-performing loans and eligibility checks on
settlement statements.

FHFA completed an amended term sheet on September 6, 2012, and four days later directed
the Enterprises to replace the existing framework with the amended framework and
commence implementation. The amended term sheet included additional details regarding
loan level eligibility criteria and exclusions from representation and warranty relief after the
relief date. The most significant changes were the addition of three loan level eligibility
criteria, including a sunset period of 12 months for a Freddie Mac Relief Refinance Mortgage
or a Fannie Mae Refi Plus or Fannie Mae DU Refi Plus mortgage.8

On September 11, 2012, FHFA and the Enterprises announced the launch of a new
representation and warranty framework for loans sold or delivered on or after January 1,
2013. The announced highlights of the new framework were:

       Sellers were relieved of certain repurchase obligations for loans that met specific
        payment requirements; for example, representation and warranty relief were provided
        for loans with 36 months of consecutive, on-time payments.

       Home Affordable Refinance Program (HARP) loans were eligible for representation
        and warranty relief after an acceptable payment history of only 12 months following
        the acquisition date.

       Information about exclusions for representation and warranty relief, such as violations
        of state, federal, and local laws and regulations, were detailed.

       Fannie Mae and Freddie Mac were to continue to make available for sellers a range of
        tools to help improve loan quality.

FHFA’s announcement of the new framework also acknowledged that it moved the focus of
quality control reviews from the time a loan defaults up to the time the loan is delivered to
Fannie Mae and Freddie Mac. FHFA also directed the Enterprises to:

       Conduct quality control reviews earlier in the loan process, generally between 30 to
        120 days after loan purchase.

8
 The Enterprises did not submit any information for FHFA to consider regarding the 12-month sunset period
applicable to these refinance mortgages despite these types of loan products accounting for a significant
portion of the Enterprises’ acquisitions. For example, in 2013, the first year for the new framework, the
Enterprises bought approximately 1.6 million refinance mortgages with an unpaid principal balance exceeding
$262 billion that were potentially subject to the 12-month sunset period.




                               OIG  AUD-2014-016  September 17, 2014                                        14
      Establish consistent timelines for sellers to submit requested loan files for review.

      Evaluate loan files on a more comprehensive basis to ensure a focus on identifying
       significant deficiencies.

      Leverage data from the tools currently used by Fannie Mae and Freddie Mac to enable
       earlier identification of potentially defective loans.

      Make available more transparent appeals processes for sellers to appeal repurchase
       requests.

FHFA Modifications to the New Representation and Warranty Framework

On May 12, 2014, the Enterprises announced that, at the direction of FHFA, a number of
significant enhancements to the framework that became effective on January 1, 2013, were
being made for loans delivered to the Enterprises on and after July 1, 2014. These changes
included:

      Relaxing the acceptable payment history requirement for determining when a
       mortgage was eligible for relief from the selling representations and warranties. For
       mortgages other than certain refinance mortgages, relief requirements were relaxed so
       that mortgages that would have previously obtained relief upon the borrower’s 60th
       monthly payment would receive relief upon the borrower’s 36th monthly payment.

      Introducing an additional path for eligible mortgages to obtain relief from selling the
       representations and warranties. In addition to the payment history path, sellers would
       also obtain relief from the representations and warranties if there were a satisfactory
       conclusion of an Enterprise quality control review of the mortgage.

      Providing sellers with written notices of mortgages that met the eligibility
       requirements for relief from the selling representations and warranties.

      Implementing an alternative to repurchase that might allow a seller to “stand in” in
       lieu of repurchasing the mortgage. The Enterprises would not automatically require a
       repurchase when notified that primary mortgage insurance had been rescinded on a
       mortgage.




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Figure 1 below illustrates the changes to the new framework for loans acquired by the
Enterprises after July 1, 2014.

  FIGURE 1. DIFFERENCES BETWEEN VERSION 1 AND VERSION 2 OF THE NEW FRAMEWORK FOR NON-
                                    REFINANCED LOANS
                                              Version 1 – Announced on       Version 2 – Announced on
             Relief Criteria                     September 11, 2012                May 12, 2014
Effective Dates                             Effective for mortgages sold    Effective for mortgages sold
                                            on and after January 1, 2013,   on and after July 1, 2014
                                            and before July 1, 2014
Number of required consecutive              36                              36
monthly payments after the Enterprise
settlement date
Number of delinquencies permitted           No delinquencies permitted      Two delinquencies of 30 days
during the first 36 monthly payments                                        or less and the 36th monthly
after the Enterprise settlement date in                                     payment is not delinquent
order to be eligible for relief after the
36th monthly payment
Opportunity to re-establish acceptable      Yes, as of the 60th monthly     Not applicable
payment history if there were               payment, provided there
delinquencies in the first 36 monthly       were no more than two
payments after the Enterprise               delinquencies of 30 days or
settlement date?                            less with the first 36 months
                                            and the 60th monthly
                                            payment is not delinquent
Eligible for relief after satisfactory      No                              Yes
conclusion of quality control review?




Source: Freddie Mac Seller-Servicer Bulletin 2014-8 (May 12, 2014).

On May 13, 2014, FHFA released its 2014 Strategic Plan for the Conservatorships of Fannie
Mae and Freddie Mac. Coinciding with the modifications to the framework announced the
day before, FHFA’s strategic plan indicated that in an effort to provide greater market
certainty, FHFA would evaluate and act, where appropriate, on changes to the framework.
Also, a component of the first strategic goal provided clarity concerning the Enterprises’
framework: “Maintain, in a safe and sound manner, foreclosure prevention activities and
credit availability for new and refinanced mortgages to foster liquid, efficient, competitive




                               OIG  AUD-2014-016  September 17, 2014                                     16
and resilient national housing finance markets.”9 Further, the strategic plan stated that lack of
clarity about representation and warranty requirements can contribute to decisions by sellers
to add credit overlays that can unnecessarily limit access to credit.10 Greater certainty
regarding both origination and servicing obligations should help increase sellers’ willingness
to more fully provide credit within the Enterprises’ underwriting standards.

FHFA is planning future changes to the new framework and is addressing the scope of life of
loan exemptions. FHFA recognizes lenders’ concerns about how these exemptions apply to
loans that have passed quality control reviews or have met the 36-month sunset period and
will work toward clarity on this issue. During the next year, FHFA will also explore:

        Establishing an independent dispute resolution program when lenders believe a
         repurchase is unwarranted;

        Developing cure mechanisms for loan defects rather than relying solely on
         repurchases; and

        Providing additional clarity on Fannie Mae and Freddie Mac underwriting rules.




9
 This strategic goal is also a major component [40%] of FHFA’s 2014 Scorecard For Fannie Mae, Freddie
Mac, and Common Securitization Solutions. With respect to the representation and warranty framework, the
Enterprises are to continue to improve the framework for originations and provide additional clarity regarding
servicing representations and warranties and remedies for poor performance, including compensatory fees.
10
   A credit overlay is terminology that describes a condition where sellers’ underwriting standards are more
stringent than those of the Enterprises. For example, a lender may place additional conditions, such as higher
credit score requirements, on top of the acceptable credit standards of each Enterprise.




                                 OIG  AUD-2014-016  September 17, 2014                                         17
FINDINGS .................................................................................

   1. FHFA Mandated a New Representation and Warranty Framework Despite
      Significant Unresolved Operational Risks to the Enterprises

FHFA directed the Enterprises to implement the new framework without allowing sufficient
time for them to fully implement and test pre- and post-loan delivery risk assessment tools,
systems used to track loan information related to the new framework, and systems that
support the Enterprises’ quality control processes. As a result, there is potentially unmitigated
risk of errors in the new loan review framework and the Enterprises may experience credit
losses that otherwise could have been avoided both by the structure of the framework and the
systems and processes employed to implement it. Nonetheless, FHFA officials have informed
OIG that the Enterprises have adequate time to prepare for supporting the new framework that
went into effect in January 2013 and have until January 2016 to prepare since that is the
earliest point at which relief could be granted for the vast majority of loans.

   Enterprise System Enhancements

Freddie Mac acknowledged in its August 2012 internal risk analysis memorandum provided
to FHFA that in order to reduce purchases of non-compliant loans with a goal of reducing
credit losses, robust pre- and post-delivery risk assessment tools and processes were critical.
In the months following, Freddie Mac continued to develop three key systems in addition to
enhancing various other systems and processes to help support the framework (see Figure 2).




                            OIG  AUD-2014-016  September 17, 2014                                 18
                FIGURE 2. FREDDIE MAC SYSTEMS DEVELOPED TO SUPPORT NEW FRAMEWORK

                System Name/Description                             Implementation Date/Status
Loan Quality Advisor (LQA): Evaluates loan data          New application that was and is still being
and provides feedback to sellers on Freddie Mac’s        implemented over a series of releases. The latest
assessment of mortgage risk prior to loan delivery.      release (#3) was deployed in March 2014.
Appraisal Data Validation System (ADVS): Receives        New application/portal/tool that was implemented
appraisals from the Uniform Collateral Data Portal       over a series of releases. The latest release (#4) was
(UCDP) and provides feedback on appraisal quality        deployed in June 2014 with additional releases
to sellers prior to loan delivery.                       planned for 2014 and 2015.
Internal Representation and Warranty Tracking            New application that was and is still being
System (IRWTS): Tracks representation and                implemented over a series of releases. The latest
warranty loan level information including the            release was deployed in June 2014 with future
representation and warranty holder and releases          releases scheduled for 2014 and early 2015.
of liability.
Source: Internally generated based on information provided to OIG by Freddie Mac.

OIG found that these systems were not expected to be fully implemented prior to January 1,
2013, the effective date of the framework as mandated by FHFA, and they are still being
implemented. As of August 2012, Freddie Mac reported in its risk analysis provided to FHFA
that the Eligibility Assessment Confirmation tool (LQA) and the Appraisal Data Validation
System (ADVS) tools were not available. However, projects were under way to deliver some
functionality during the first quarter of 2013, and full functionality was expected to be
delivered over the following two years. Freddie Mac also reported that a new tracking system
(IRWTS) had to be built to support the new framework. The importance of this system is
highlighted by Freddie Mac’s assessment that its most significant process risk is associated
with accurately capturing the representation warranty holder throughout the life of the loan.
Further, this assessment indicates that a tracking system must be built to support the
representation and warranty sunset period to mitigate operational risk.

In addition, FHFA was aware that Freddie Mac did not have a system tool to assess electronic
appraisal information and had not made a decision regarding such a tool as of September
2012. Accordingly, in conjunction with Fannie Mae, FHFA arranged a demonstration of
Fannie Mae’s CU system (Fannie Mae’s appraisal system) for Freddie Mac to consider. At the
time, FHFA was aware that this system was only being tested among three of Fannie Mae’s
seller-servicers and was not a proven solution.11 Due to Freddie Mac’s concerns regarding
CU, including its ability to connect with other commercially available tools/applications and

11
     See footnote 7, supra.




                               OIG  AUD-2014-016  September 17, 2014                                        19
its suitability for business processes, Freddie Mac developed a new system to fulfill this
critical function. This new system, ADVS, was initially deployed in June 2014 to include
functionality to evaluate appraisal quality.

Despite FHFA’s awareness that Freddie Mac would not have the systems and tools in place
it deemed necessary to help identify non-compliant loans and reduce credit losses, FHFA
continued with its January 1, 2013, implementation for the new framework. Consequently,
FHFA did not determine the impact of system implementation delays on Freddie Mac’s
ability to identify loan defects prior to the applicable sunset period (12 or 36 months) for
loans purchased after January 1, 2013, or ensure that mitigating controls were in place.
Further, based on information OIG obtained from Freddie Mac in July 2014, its systems
still may not have the necessary functionality to fully support the new framework.12

As shown in Figure 2, LQA, ADVS, and IRWTS are still being implemented through a
series of releases. For example, IRWTS was initially deployed in October 2013 to include
functionality to internally establish and monitor framework sunset dates. In November 2013
and June 2014, additional releases were deployed to add functionality to fulfill and support
additional framework requirements such as new data control reports and establishing rules
for bifurcated servicing transfers. Further releases are planned for late 2014 and early 2015 to
implement capabilities to comply with the new framework mandate to provide record of relief
to seller/servicers that satisfy applicable sunset eligibility requirements.

Likewise, FHFA did not determine whether Fannie Mae had the necessary systems in place
to support the framework. Based on information provided to OIG in July 2014, Fannie Mae
had to implement or enhance numerous systems to support the new framework and is still
enhancing CU and Relational Data Warehouse (RDW) to leverage their full functionality (see
Figure 3).




12
  FHFA’s analysis supporting its enhancements to the new framework that were announced in May 2014 also
did not address whether the Enterprises had appropriate systems, tools, and processes in place to support the
new framework as well as the enhancements that were to be effective on July 1, 2014, only two months later.




                                OIG  AUD-2014-016  September 17, 2014                                         20
             FIGURE 3. FANNIE MAE SYSTEMS DEVELOPED TO SUPPORT NEW FRAMEWORK

             System Name/Description                                 Implementation Date/Status
Early Check: Provides feedback on loan eligibility       June 2013 – Fannie Mae enhanced Early Check
to sellers prior to loan delivery.                       to include additional loan delivery edits for loan
                                                         quality purposes, helping sellers to ensure that
                                                         loans are eligible for delivery to Fannie Mae from
                                                         a credit/data perspective earlier in the loan
                                                         manufacturing process.
Quality Assurance System (QAS): Tracks the status        July 2014 – Fannie Mae completed enhancements
of loan reviews for loans that Fannie Mae has            to incorporate new quality control workflows and
selected for quality assurance reviews.                  the new loan defect framework.
Collateral Underwriter: Evaluates the quality of         Initial implementation June 2013 – As of July 2014,
appraisal information and is expected to play a          CU was piloted with six Fannie Mae seller-servicers.
central role in post purchase reviews to detect          Broader industry rollout is expected with a future
appraisal data errors and inconsistencies among          release.
appraisers and appraisals, among other things.
Appraisal and Underwriting Model: Performs a risk        June 2013
assessment of all new loans by measuring the
likelihood of loan defects.
Relational Data Warehouse: RDW is the current            Third Quarter of 2015 – Full integration of the
system of record for tracking the representation         representation and warrant implications of QC
and warranty status for all loans at the individual      review results and corresponding remedial actions
loan level. The RDW solution tracks status by            with RDW will provide a central system of record.
payment history (implemented in February 2014),
but does not currently interface with QAS.
Source: Internally generated based on data provided to OIG by Fannie Mae.

    FHFA Examination Coverage

OIG also found that despite significant changes to the Enterprises’ systems and processes,
FHFA has performed limited work to ensure that necessary controls are in place and operating
effectively prior to the applicable sunset periods. The Enterprises needed to shift the primary
focus of their quality control efforts from nonperforming loans where underwriting defects
may be more obvious to the larger population of performing loans within the sunset period.
Yet, the Division of Enterprise Regulation (DER) has performed limited work with respect to
the quality control processes that Freddie Mac implemented to accommodate the new




                               OIG  AUD-2014-016  September 17, 2014                                        21
framework.13 Aside from an evaluation of Relief Refinance Mortgage Performance following
the sunset period during the third quarter of 2014, FHFA does not intend to conduct further
reviews specific to the new framework quality control processes within the scope of the 2014
examination plan, but will consider incorporating this activity into the 2015 plan.14
Furthermore, DER has not examined any of the systems that Freddie Mac identified in its risk
analysis that it needed to establish or enhance to support the new framework.

As for Fannie Mae, DER has no scheduled exams that cover the new framework or the quality
control processes and systems needed by the Enterprise to accommodate the framework. The
Agency indicated that there was coverage from ongoing monitoring of the NUC through
attending executive meetings, but there was no targeted monitoring or specific examinations
of the framework.

FHFA’s implementation of the framework in January 2013 did not adequately consider
operational risks related to implementation of an appropriate infrastructure to support the
new framework through upfront monitoring of loan quality and post-purchase quality control
prior to the sunset period. This lack of due diligence on FHFA’s part is significant since the
implications of not having the necessary systems, tools, and processes in place impacts the
Enterprises’ ability to: (1) conduct quality control reviews earlier in the loan process, generally
between 30 to 120 days after loan purchase; (2) evaluate loan files on a more comprehensive
basis to ensure a focus on identifying significant deficiencies, and (3) leverage data from the
tools currently used by Fannie Mae and Freddie Mac to enable earlier identification of
potentially defective loans as mandated by FHFA. Without adequate systems and processes,
achieving a positive economic outcome for the Enterprises through implementation of the new
framework is uncertain. Conversely, the sellers stand to benefit from the lack of preparation as
loans start to pass the sunset dates without thorough screening of their quality.




13
  FHFA completed a targeted examination of Freddie Mac’s quality control sampling methodologies for
credit risk management on March 31, 2014, and concluded that performing and non-performing sampling
methodologies were adequate.
14
  Freddie Mac Relief Refinance mortgages, Fannie Mae Refi Plus, and Fannie Mae DU Refi Plus mortgages
have a sunset period of either: (a) 12 consecutive months of on-time payments in accordance with the
refinanced loan’s terms following acquisition, or (b) following acquisition, current on the 60th month in
accordance with the refinanced loans terms, provided that there are no more than two 30-day delinquencies and
no 60-day delinquencies in the first 36 months.




                                OIG  AUD-2014-016  September 17, 2014                                         22
     2. FHFA Mandated a 36-Month Sunset Period for Representation and Warranty
        Relief Without Validating the Enterprises’ Analyses or Performing Sufficient
        Analysis Needed to Appropriately Balance Financial Risk Between the
        Enterprises and Sellers

FHFA mandated a 36-month sunset period for representation and warranty relief using
inconsistent and incomplete analyses from the Enterprises that were not validated or
independently tested. As a result, the cost/benefit of this approach has not been clearly
demonstrated. Further, FHFA understood from analysis provided by Freddie Mac that a
48-month sunset period might carry less risk to the Enterprises, but selected the 36-month
sunset period in the absence of any quantifiable benefit to the Enterprises. Accordingly, the
36-month sunset period may not appropriately balance financial risk between the Enterprises
and sellers.

     Enterprise Analyses

FHFA’s decision-making process concerning the new framework was not supported by
complete, thorough, and consistent analysis. FHFA asked each Enterprise to provide their
recommendation for a sunset period in the new framework, accompanied by supporting data,
but did not require each Enterprise to perform consistent analyses using comparable data. As
a result, the analyses and recommendation received from each Enterprise were inconsistent.
Fannie Mae recommended a 36-month sunset period and Freddie Mac recommended a
48-month sunset period.15 As reflected in Figure 4 below, the analyses supporting each
recommendation were not uniform and therefore not comparable across each Enterprise.
Nonetheless, FHFA did not perform any procedures to validate the underlying mortgage data,
test the results furnished by the Enterprises, or direct the Enterprises to re-work their analysis
using the same criteria, such as consistent sampling methodologies and vintages of the
mortgages selected for review. FHFA also did not develop an understanding of any measures
taken by the Enterprises to validate this data. FHFA informed OIG that due to differences in
data availability and systems at each Enterprise, it is impossible to receive analyses with
identical data and characteristics. FHFA also stated that it is not possible to independently
validate specific GSE data.


15
  FHFA’s frequently asked questions document that was attached to its September 11, 2012, news release
concerning the launch of the new representation and warranty framework stated: “Among industry members
consulted, there were various suggestions on the timing of the relief, the most prevalent being 36 months.
Freddie Mac and Fannie Mae, in consultation with FHFA, concluded that 36 months would enable Fannie Mae
and Freddie Mac to conduct sampling and analyses needed to confirm eligibility of the mortgage loans
acquired, and would show the borrower’s ability to repay the loan according to its terms.”




                               OIG  AUD-2014-016  September 17, 2014                                       23
In addition, FHFA did not require Fannie Mae to prepare any analyses to assess a 48-month
sunset period, which Freddie Mac’s analysis indicated carried less risk than a 36-month sunset
period. Furthermore, FHFA did not require the Enterprises to provide data that would show
whether the new framework was cost beneficial over the existing framework. FHFA informed
OIG that cost/benefit considerations, such as determining if the new framework had economic
advantages over the existing framework, were not relevant to the purpose of revising the
representation and warranty framework. Rather, the focus was on ensuring broader access
to credit.

        FIGURE 4. INCONSISTENCIES BETWEEN THE ENTERPRISES’ SUNSET PERIOD ANALYSIS AND
                                      RECOMMENDATIONS

                    Fannie Mae                                                Freddie Mac
                                                         Analysis performed for 36- and 48-month sunset
Analysis performed for 36-month sunset period
                                                         periods
                                                         Sampled loans funded during 2004, 2005, and
Sampled loans acquired from 2003 through 2010
                                                         2006
Sample size of 43,103 loans                              Sample size of approximately 8,000 loans
                                                         Includes information for lifetime defaults for loans
No information for defaults after year 5
                                                         with 36- and 48-month clean pay history
Recommendation: 36-Month Sunset Period                   Recommendation: 48-Month Sunset Period
Source: FHFA OHRP Concept Approval Request (May 25, 2012).

According to FHFA’s Concept Approval Request, data provided by Fannie Mae indicates that
for 2003-2010 acquisitions with 36 consecutive on time payments, approximately 6.1% of the
loans defaulted in years 4 and 5 and subsequently had defects. FHFA concluded that for those
loans with a clean payment history in the first 36 months that default in the subsequent two
years, there is a very small percentage with a defect so a repurchase or some other remedy
could be requested.16

Freddie Mac’s scenario analysis data from 2004-2006 acquisitions indicates that the
percentage of the first 5-year defaults found in mortgages with 36 months of clean pay history
that subsequently defaulted in years 4 and 5 that could have a repurchaseable defect was
approximately 3.7%; meanwhile, loans with 48 months of clean pay history that subsequently

16
  The very small percentage referred to by FHFA is 6.1%. According to Fannie Mae’s analysis, this
percentage was derived by dividing the number of reviewed loans with 36-month clean pay histories that
defaulted in years 4 and 5 with findings (2,634) by the total number of those loans that defaulted (43,103),
which yields a finding rate of 6.11%.




                                 OIG  AUD-2014-016  September 17, 2014                                        24
defaulted in year 5 and could have had repurchaseable defects was approximately 1.3%.17
FHFA concluded that given the improved quality of underwriting practices and standards,
these percentages should be smaller in more recent book years, as well as in prospective
business. Analytics, according to FHFA, also reveal that a very high percentage of
acquisitions do in fact achieve 36 months of consecutive on-time payments following
acquisition—approximately 90% of Freddie Mac’s fixed-rate mortgages in funding years
2004-2006. Therefore, the majority of acquisitions should meet the clean pay history
eligibility criteria.18

       FHFA Independent Validation

FHFA did not independently analyze financial risks posed to the Enterprises by the sunset
periods or ask either Enterprise to perform any further analysis. Neither Enterprise provided
information that detailed the years in which each loan defaulted over the life of the loan and
Fannie Mae provided no information about lifetime defects for loans with a 36-month clean
payment history that defaulted after year 5. This is significant since the defect rate on a
defaulted loan is higher over the life of the loan than for defaults in years 4 and 5.

For example, according to Freddie Mac’s analysis, defects on loans with 36 months of clean
pay history within five years is 3.7%, but increased to 12.3% for the lifetime of the loan.19
Consequently, most of the risk of foregoing potential recoveries appears to occur after year 5.
Although Freddie Mac did not quantify the percentages in dollars, this difference is the risk
being borne by the Enterprises that no longer have the repurchase remedy available to them if
underwriting quality problems exist. Moreover, this increased defect risk cannot be further
analyzed or quantified without default rate information that could help identify peak default
years beyond year 5 and resulting credit loss risk. For example, Freddie Mac reported in its
May 2014 Credit Results Management Summary that for its loan portfolio as of May 31,
2014, 96% of its credit losses resulted from loans originated in 2010 or prior. While OIG

17
  The analysis provided by Freddie Mac also provided comparable lifetime of loan defects that averaged
12.3% (36 months of clean pay history) and 8.3% (48 months of clean pay history). In the process of validating
this information pursuant to its review of OIG’s report, Freddie Mac identified an error and issued a disclaimer.
Freddie Mac’s disclaimer states in part that this information has been assembled on an expedited basis in order
to provide FHFA with information responsive to its request. As such, it reflects preliminary information, and it
has not been subjected to the rigorous review to which Freddie Mac typically subjects information prior to
dissemination and that the expedited nature of the production should be kept in mind as this information is
reviewed.
18
  This percentage indicates that completing quality control reviews within 36 months of acquisition is critical
for the Enterprise since 90% of the loans in the sample would qualify for representation and warranty relief
under the new framework.
19
     See footnote 17, supra.




                                 OIG  AUD-2014-016  September 17, 2014                                            25
recognizes that this percentage includes losses on legacy loans still on Freddie Mac’s books,
the data suggests that default and credit loss risk is highest after three years from loan
origination, not before.20

In addition, FHFA did not follow up with Fannie Mae on defect rates on defaulted loans with
48 months of clean pay history or assess the financial impact that either sunset period would
have on the Enterprises. Instead, FHFA mandated a 36-month sunset period knowing that it
exposed the Enterprises to increased financial risk over a longer sunset period without
measurable benefits.




20
  Many loan products, for example, have adjustable rates and borrowers can experience payment shock
resulting from increasing interest rates.




                               OIG  AUD-2014-016  September 17, 2014                                26
CONCLUSION ............................................................................

The new representation and warranty framework is a component of FHFA’s Contract
Harmonization Project that was designed to improve the Enterprises’ contracts with sellers,
maximizing both seller performance and economic return on the Enterprises’ loan portfolios.
The operational and financial risks of implementing the new framework should be
appropriately balanced between the Enterprises and sellers and include consideration of the
Agency’s goals and objectives including those related to credit availability. OIG’s work
demonstrates that strengthening the Agency’s oversight will help FHFA achieve its goals and
assist the Enterprises with operating safely and soundly under the new framework.




                          OIG  AUD-2014-016  September 17, 2014                             27
RECOMMENDATIONS ...............................................................

OIG recommends that FHFA:

   1. Assess the current state of the Enterprises’ critical risk assessment tools,
      representations and warranties tracking systems, and any other systems, processes, or
      infrastructure to determine whether the Enterprises are in a position to minimize
      financial risk that may result from the new framework. The results of this assessment
      should document any areas of identified risk, planned actions, and corresponding
      timelines to mitigate each area of identified risk. Further, this assessment should
      provide an estimate of when each Enterprise will be reasonably equipped to work
      safely and soundly within the new framework.

   2. Perform a comprehensive analysis to assess whether financial risks associated with the
      new representation and warranty framework, including with regard to sunset periods,
      are appropriately balanced between the Enterprises and sellers. This analysis should be
      based on consistent transactional data across both Enterprises, identify potential costs
      and benefits to the Enterprises, and document consideration of the Agency’s
      objectives.




                          OIG  AUD-2014-016  September 17, 2014                                28
OBJECTIVES, SCOPE, AND METHODOLOGY ...............................

The objective of this performance audit was to assess FHFA’s oversight of Fannie Mae’s and
Freddie Mac’s implementation of the new representation and warranty framework that began
in January 2013.

OIG conducted this performance audit from January 2014 through June 2014. OIG conducted
this audit in Washington, D.C., at the headquarters of FHFA and Fannie Mae, and in McLean,
VA, at Freddie Mac’s headquarters.

The scope of OIG’s audit involved FHFA’s new representation and warranty framework, the
Enterprises’ ability to function in a safe and sound manner under the new framework, and
whether operational and financial risks were appropriately balanced between the Enterprises
and their sellers. For purposes of this audit, OIG did not assess controls over computer-
processed data.

To achieve the audit objective, OIG:

      Reviewed FHFA directives, guidelines, announcements, analyses, and other internal
       and external communications and documents concerning the new representation and
       warranty framework that became effective in January 2013;

      Interviewed Fannie Mae and Freddie Mac officials responsible for providing
       information to FHFA in response to requests for research and analysis regarding
       potential changes to the representation and warranty framework; and

      Interviewed FHFA officials responsible for developing elements of the new
       representation and warranty framework and providing guidance to the Enterprises on
       implementation of the new framework.

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

      Effectiveness and efficiency of operations;

      Reliability of financial reporting; and

      Compliance with applicable laws and regulations.




                            OIG  AUD-2014-016  September 17, 2014                                29
Internal controls relate to management’s plans, methods, and procedures used to meet its
mission, goals, and objectives, and include the processes and procedures for planning,
organizing, directing, and controlling program operations as well as the systems for
measuring, reporting, and monitoring program performance. Based on the work completed
on this performance audit, OIG considers its findings on FHFA’s new representation and
warranty framework to be significant deficiencies within the context of the audit objective.

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




                           OIG  AUD-2014-016  September 17, 2014                             30
APPENDIX A .............................................................................

FHFA’s Comments on OIG’s Findings and Recommendations




                        OIG  AUD-2014-016  September 17, 2014                        31
OIG  AUD-2014-016  September 17, 2014   32
OIG  AUD-2014-016  September 17, 2014   33
APPENDIX B..............................................................................

OIG’s Response to FHFA’s Comments

On September 3, 2014, FHFA provided comments to a draft of this report. FHFA partially
agreed with recommendation 1 and disagreed with recommendation 2. OIG has attached
FHFA’s full response as Appendix A, and considered it where appropriate in finalizing this
report. Appendix C provides a summary of the Agency’s response to OIG’s recommendations
and the status of agreed-upon corrective actions.

With respect to recommendation 1, DER will request and review information from the
Enterprises about operational changes needed at each Enterprise for safe and sound
implementation of the new framework and will take this into account in developing its
examination plans for 2015. Although FHFA’s planned corrective action is potentially
responsive to OIG’s recommendation, it is not clear what specific steps FHFA plans to take
or how it plans to document the results of the recommended assessment, including areas
of identified risk, planned actions, timelines to mitigate each area of identified risk, and
estimates of when each Enterprise will be reasonably equipped to perform loan quality
review safely and soundly within the new framework. Accordingly, the content of FHFA’s
assessment and examination coverage will determine whether the Agency’s planned
corrective action is responsive to this recommendation. OIG considers FHFA’s answer to
be potentially responsive to resolve this recommendation, which will remain open until
OIG determines that agreed-upon corrective actions are completed and responsive to this
recommendation.

OIG’s recommendation 2 requested FHFA to perform a comprehensive analysis to assess
whether financial risks associated with the new framework, including the sunset periods, are
appropriately balanced between the Enterprises and sellers. OIG further requested that this
analysis be based on consistent transactional data across both Enterprises, identify potential
costs and benefits to the Enterprises, and document consideration of the Agency’s objectives.

In response to recommendation 2, FHFA asserts that revisiting its decisions regarding the new
framework sunset periods and related payment history requirements to prepare an analysis of
the financial risks associated with a previous release of the framework may have adverse
market effects on future revisions to the framework, and may not align with the FHFA
objective of increased lending to consumers consistent with Enterprise safety and soundness.
FHFA also stated that adaptation and implementation of the revised framework have begun
at the Enterprises and the level of effort involved to produce an analysis on a previous




                           OIG  AUD-2014-016  September 17, 2014                               34
framework may not yield any economic benefit to either the Enterprises or stakeholders as
revisions to the framework continue.

Importantly, FHFA did agree going forward to enhance the documentation and analysis,
including identifying and addressing Enterprise risks, surrounding decisions that will impact
the representation and warranty framework. Further, FHFA stated it will continue to evaluate,
document, and revise the framework, taking into account stakeholder comments and various
market factors in order to improve credit access for consumers, consistent with Enterprise
safety and soundness. In this regard, OIG did not see that FHFA fully considered the
economic impact and in turn the safety and soundness of the Enterprises in the analysis
supporting the initial release of the framework in September 2012. Thus, the actions identified
by FHFA are positive steps and can go a long way toward meeting the intent of OIG’s
recommendation.

FHFA announced the objective of the new framework was to clarify lenders’ repurchase
exposure and liability on future deliveries. OIG remains concerned that FHFA has not fully
developed the economic impact to the Enterprises, and in turn taxpayers that have been
called upon to financially support them, associated with the limits on lender liability in the
framework. The potential consequences of continued implementation of the new framework
are substantial and warrant more careful consideration by FHFA. OIG did not intend for
FHFA to construct the support for its past decisions regarding the framework although
such support was deemed lacking. Rather, OIG intended for FHFA to assess the results of
implementation of the framework and in particular whether risks are appropriately balanced
between the Enterprises and lenders based on current and projected loan performance, market
information, and other relevant factors. Without a comprehensive analysis to assess potential
economic impacts on the Enterprises associated with the framework and its revisions in order
to establish a baseline to measure performance, FHFA is unable to make fully informed
decisions regarding the need for and financial risks associated with further updates to
the framework as the agency stated it would do.

Currently, FHFA does not have a full understanding of how such risks, including those
associated with the sunset periods, are balanced between the Enterprises and lenders.
Furthermore, FHFA has not determined whether its other objective of increased lending
to consumers is being achieved through the new framework and at what cost or whether
the Enterprises are operating in a safe and sound manner under the new framework.
Consequently, OIG considers recommendation 2 to be unresolved and requests that within
30 days of the issuance of this report, FHFA reconsider its position and provide OIG with a
revised response.




                           OIG  AUD-2014-016  September 17, 2014                                35
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
Rec.                Corrective Action:               Completion       Monetary         Resolveda        Open or
No.                 Taken or Planned                    Date          Benefits         Yes or No        Closedb
        FHFA partially agrees with this
        recommendation. DER examination
        staff will request the Enterprises
        to provide information about
        operational changes needed at
1       each Enterprise for safe and sound          01/31/2015            $0              Yes               Open
        implementation of the new
        framework, and DER will take
        this information into account in
        developing its examination plans
        for 2015.
        FHFA disagrees with this
        recommendation and will not perform
        an analysis of the financial risks
        associated with the new framework
        as revisiting decisions regarding the
        representation and warranty
        framework sunset periods and the
2                                                   N/A                   $0               No               Open
        related payment history requirements
        may have adverse market impact on
        future revisions to the framework and
        may not align with the FHFA objective
        of increased lending to consumers,
        consistent with Enterprise safety and
        soundness.
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 the agreed-upon corrective actions have been completed and are responsive, the
recommendations can be closed.




                                OIG  AUD-2014-016  September 17, 2014                                            36
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




                            OIG  AUD-2014-016  September 17, 2014                        37