oversight

Recent Trends in the Enterprises' Purchases of Mortgages from Smaller Lenders and Nonbank Mortgage Companies

Published by the Federal Housing Finance Agency, Office of Inspector General on 2014-07-17.

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

          Federal Housing Finance Agency
              Office of Inspector General




Recent Trends in the Enterprises’
  Purchases of Mortgages from
     Smaller Lenders and
 Nonbank Mortgage Companies




Evaluation Report  EVL-2014-010  July 17, 2014
                Recent Trends in the Enterprises’ Purchases of
                Mortgages from Smaller Lenders and Nonbank
                Mortgage Companies

                Why OIG Did This Report
                The Federal National Mortgage Association (Fannie Mae) and the Federal
                Home Loan Mortgage Corporation (Freddie Mac) (collectively, the
 At A           Enterprises) provide liquidity for housing finance by purchasing mortgage
Glance          loans from primary mortgage lenders and securitizing them for sale in the
                secondary mortgage market. In recent years, the Enterprises have seen a shift
  ———           in the composition of their mortgage sellers, with relatively fewer sales from
                large depository institutions and more sales from smaller lenders and nonbank
July 17, 2014   mortgage companies.

                This evaluation report documents the increase in sales to the Enterprises by
                smaller lenders and nonbank mortgage companies, discusses the reasons
                behind this trend, and assesses the Federal Housing Finance Agency’s (FHFA
                or Agency) oversight of the Enterprises’ risk management controls.

                OIG Analysis
                Traditionally, the Enterprises bought most of their loans from the largest
                commercial banks and mortgage companies. These entities sold the
                Enterprises mortgages that they originated or purchased from smaller,
                independent lenders. Since 2011, however, the largest commercial banks and
                mortgage companies have reduced their purchases from smaller lenders and,
                therefore, sold fewer loans to the Enterprises. The figure below shows the
                decline in the market share of the Enterprises’ respective top five mortgage
                sellers.

                Smaller mortgage         FIGURE 5. MARKET SHARE OF THE ENTERPRISES’ TOP
                originators and                   FIVE SELLERS (2003 Q1–2013 Q3)
                nonbank mortgage
                                         85%
                companies have                                       Fannie Mae       Freddie Mac

                responded to the         75%

                changing market          65%
                by developing direct
                                         55%
                sales relationships
                with the Enterprises,    45%

                thereby increasing       35%
                their market share.         2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
                Counterparty Risks Presented by Some Small and Nonbank Sellers
                The increase in mortgage sales to the Enterprises by smaller lenders and
                nonbank mortgage companies presents the Enterprises with certain potential
                benefits and risks. For example, the shift in market share among the
                Enterprises’ sellers reduces the Enterprises’ highly concentrated financial
                exposure to their largest counterparties. However, the shift may also increase
                their exposure to certain risks and raises their costs for counterparty risk
 At A           management. For example:

Glance                Smaller and nonbank lenders may have relatively limited financial
                       capacity, and the latter are not subject to federal safety and soundness
  ———                  oversight. Thus, the Enterprises face an increase in the risk that those
July 17, 2014          counterparties could default on their financial obligations;

                      Such lenders may lack the sophisticated systems and expertise
                       necessary to manage high volumes of mortgage sales to the Enterprises,
                       thereby increasing the risk that the Enterprises will suffer losses on
                       such transactions; and,

                      Some nonbank lenders may present the Enterprises with an elevated
                       risk of reputational harm. For example, we identified one such
                       institution that was sanctioned by state regulators for engaging in
                       abusive lending practices.

                FHFA’s Oversight of the Enterprises’ Risk Controls for Small and Nonbank
                Lenders
                During 2013, FHFA conducted high-level examinations of the Enterprises’
                counterparty risk management controls and reviewed the risks associated with
                specialized mortgage servicers. However, we concluded that, due to other
                examination priorities, FHFA did not test and validate the effectiveness of
                the controls put in place by the Enterprises to address the recent increase in
                mortgage sales from smaller and nonbank lenders.

                The Agency’s 2014 planning documents indicate that it has scheduled several
                examinations of the Enterprises’ management of the risks associated with their
                smaller lenders and nonbank mortgage companies. Further, FHFA officials
                said that the Agency is developing guidance intended to strengthen the
                Enterprises’ counterparty risk management.

                We will continue monitoring the effectiveness of the Agency’s efforts to
                oversee this critical issue.

                FHFA and the Enterprises provided us with technical comments on this report.
TABLE OF CONTENTS ................................................................

AT A GLANCE ...............................................................................................................................2

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

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

CONTEXT .......................................................................................................................................9
      The Enterprises Purchase Mortgages Primarily from Depository Institutions and
      Nonbank Mortgage Companies ................................................................................................9
              Depository Institutions ......................................................................................................9
              Mortgage Companies ......................................................................................................10
      Overview of the Enterprises’ Mortgage Sale Processes .........................................................11
              The Enterprises Set Loan Quality Standards for the Mortgages they Purchase
                  from Lenders ...........................................................................................................11
              Lenders Swap their Mortgages for MBS or Sell them for Cash .....................................11
              The Enterprises May Require Sellers to Repurchase Mortgages that Do Not
                  Comply with their Underwriting Standards ............................................................12
              Lenders Often Service the Mortgages They Sell to the Enterprises ...............................13
      Large Financial Institutions May Aggregate and Sell Smaller Lenders’ Mortgage
      Loans to the Enterprises..........................................................................................................13
              The Aggregation System Offered Financial and Other Benefits to the
                  Participants ..............................................................................................................14
              Many Aggregators Have Failed or Withdrawn from the Business Since the
                 Financial Crisis Due to Changing Economic Circumstances and Regulatory
                 Initiatives .................................................................................................................15
      Smaller Lenders and Nonbank Mortgage Companies Have Increased Their Direct
      Sales of Mortgages to the Enterprises ....................................................................................17
              The Number of Active Seller Counterparties Has Increased at Both Enterprises ..........17
              The Market Share of the Enterprises’ Largest Mortgage Sellers Has Declined
                  Significantly ............................................................................................................18
              Significant Increase in Mortgage Lender Cash Sales to the Enterprises ........................19
              Increased Sales Percentages from Nonbank Mortgage Companies................................20


                                              OIG  EVL-2014-010  July 17, 2014                                                               4
             Nonbank Specialty Servicers Have Initiated Mortgage Sales to the Enterprises ...........22
      Risks and Challenges Associated with the Increase in Mortgage Sales by Smaller
      Lenders and Nonbank Mortgage Companies .........................................................................23
             Elevated Counterparty Credit Risks ...............................................................................23
             Elevated Operational Risks .............................................................................................26
             Elevated Reputational Risk .............................................................................................26
      The Risk Management Controls Put in Place by the Enterprises to Address the
      Increase in Direct Sales from Smaller Lenders and Nonbank Mortgage Lenders .................27
      FHFA’s Oversight of the Enterprises’ Risk Management Controls for Mortgage
      Sales from Smaller Lenders and Nonbank Mortgage Companies ..........................................29
             FHFA’s Examiners Assessed the Enterprises’ General Counterparty and
                Specialized Mortgage Servicer Risk Management in 2013, but Did Not
                Focus on their Controls for Smaller and Nonbank Lenders ....................................29
             DER Plans to Conduct Examination Activities in 2014 .................................................30
             DSPS Has Issued, and Is Developing, Guidance for the Enterprises on
                Counterparty Risk Management ..............................................................................31

CONCLUSIONS............................................................................................................................32

OBJECTIVE, SCOPE, AND METHODOLOGY .........................................................................33

ADDITIONAL INFORMATION AND COPIES .........................................................................34




                                            OIG  EVL-2014-010  July 17, 2014                                                          5
ABBREVIATIONS .......................................................................

DER                Division of Enterprise Regulation

DHMG               Division of Housing Mission and Goals

DSPS               Division of Supervision Policy and Support

EIC                Examiner in Charge

Enterprises        Fannie Mae and Freddie Mac

FDIC               Federal Deposit Insurance Corporation

Fannie Mae         Federal National Mortgage Association

Freddie Mac        Federal Home Loan Mortgage Corporation

FHFA or Agency     Federal Housing Finance Agency

FSOC               Financial Stability Oversight Council

MBS                Mortgage-Backed Security

OCA                Office of the Chief Accountant

OCC                Office of the Comptroller of the Currency

OFAMS              Office of Financial Analysis, Modeling and Simulations

OIG                Federal Housing Finance Agency Office of Inspector General

UPB                Unpaid Principal Balance




                           OIG  EVL-2014-010  July 17, 2014                       6
PREFACE ...................................................................................

Fannie Mae’s and Freddie Mac’s statutory mission is to provide stability, affordability, and
liquidity to the secondary market for residential mortgages.1 The Enterprises carry out this
mission by purchasing qualifying mortgage loans from the banks and other lenders that
originate them. The Enterprises then bundle the loans into mortgage-backed securities (MBS)
that may be purchased by investors.2

Historically, large commercial banks and other financial companies often acted as loan
“aggregators,” purchasing mortgages originated by smaller lenders and selling them to the
Enterprises along with loans they originated through their own lending operations.3 The
aggregators were responsible for ensuring that the loans they sold to the Enterprises met their
underwriting standards.

This system benefitted both the smaller lenders and the Enterprises. The smaller lenders
received favorable compensation for their mortgage loans, and the Enterprises were able
to focus their counterparty risk oversight on the performance of the relatively few large
aggregators from which they bought the majority of their mortgage loans.

Since the financial crisis of 2007, many of the surviving large aggregators have reduced the
amount of loans they purchase from other lenders, and they sell fewer loans to the Enterprises.
Consequently, smaller lenders sell substantially more loans directly to the Enterprises, as do a
class of financial institutions known as nonbank mortgage companies.4

The increase in purchases directly from smaller financial institutions and nonbank mortgage
companies offers the Enterprises some potential benefits, such as lower concentration risk.5
On the other hand, it may increase counterparty credit risk, which stems primarily from two
sources. First, some smaller lenders and nonbank mortgage companies have limited financial
capacity; second, in some instances, they are subject to less comprehensive federal oversight
1
 See Federal National Mortgage Charter Act (12 U.S.C. 1716) and Federal Home Loan Mortgage Corporation
Act (12 U.S.C. 1451 Note).
2
 The Enterprises’ contribution to the secondary mortgage market is substantial. During 2013, Fannie Mae and
Freddie Mac securities accounted for 76% of all new MBS issuances.
3
    In this report, we define small lenders based on their quarterly mortgage sales volume to the Enterprises.
4
    See page 10 for a definition of, and additional information about, nonbank mortgage companies.
5
  The highly concentrated nature of the Enterprises’ business with several large financial institutions places the
Enterprises at risk that their financial condition and operations could be significantly affected if one of their
large counterparties fails, defaults on its contractual obligations, or ceases doing business with an Enterprise.
Thus, diversification of mortgage sales among a broader pool of smaller sellers has reduced the Enterprises’
concentration risk.




                                        OIG  EVL-2014-010  July 17, 2014                                           7
than larger financial institutions. Consequently, some may pose a heightened risk of financial
loss to the Enterprises.

In this report, we discuss the recent rise in direct sales to the Enterprises by smaller financial
institutions and nonbank mortgage companies and several of the reasons behind this trend.
We also identify the risks and challenges associated with it, and discuss FHFA’s and the
Enterprises’ risk management and oversight efforts.

This report was prepared by Simon Z. Wu, Ph.D., Chief Economist; Jon Anders, Program
Analyst; and Wesley M. Phillips, Director of the Division of Oversight and Review. We
appreciate the cooperation of all those who contributed to this effort.

This 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.




Richard Parker
Deputy Inspector General for Evaluations




                                 OIG  EVL-2014-010  July 17, 2014                                  8
CONTEXT ..................................................................................

The Enterprises Purchase Mortgages Primarily from Depository Institutions and
Nonbank Mortgage Companies

The majority of the Enterprises’ mortgage lender counterparties are depository institutions,
their subsidiaries, and nonbank mortgage companies.6 Depository institutions and nonbank
mortgage companies both contribute substantially to housing finance. However, as described
below, there are distinct differences in their business models and the degree to which they are
regulated.

      Depository Institutions

Depository institutions, referred to in this report as banks, are financial firms whose primary
business is taking deposits and making loans. A governmental entity at the national or
state level charters them, and their deposits are insured, in part, against loss. In addition,
depository institutions are subject to federal supervision, including examinations of their
financial safety and soundness. Depository institutions are:

          Commercial banks, which are chartered at the state or national level and subject to
           state or federal regulatory supervision. On the federal level, supervision may be
           provided by the Office of the Comptroller of the Currency (OCC), the Federal Reserve
           System, or the Federal Deposit Insurance Corporation (FDIC).7 The FDIC also
           insures deposits in commercial banks for at least $250,000. In addition to taking
           deposits and lending, commercial banks may operate other business lines, including
           investment banking and credit card operations. Commercial banks vary in size from
           small community lenders to the largest national bank holding companies.8 As a
           general matter, large commercial banks have better access to financing and capital
           than other financial institutions.


6
  The Enterprises also purchase single-family mortgage loans from state and local housing finance agencies,
insurance companies, and investment banks, among others. According to data provided by the Enterprises,
depository institutions, their subsidiaries, and nonbank mortgage companies supplied nearly 100% of their
mortgages in the third quarter of 2013.
7
    The Federal Reserve, FDIC, and state bank regulators oversee state chartered commercial banks.
8
  According to the FDIC, community banks are often privately owned, operate within a limited market area,
and are more likely to engage in mortgage lending based on specialized knowledge of their community rather
than the model-based underwriting employed by larger banks. See FDIC, FDIC Community Banking Study,
“Chapter 1 – Defining the Community Bank,” at 1-1, 1-5 (December 2012) (online at:
http://fdic.gov/regulations/resources/cbi/report/CBSI-1.pdf).




                                       OIG  EVL-2014-010  July 17, 2014                                     9
          Credit unions, which are member-owned, not-for-profit financial cooperatives that
           provide savings, credit, and other financial services to their members. Credit unions
           pool their members’ savings deposits and shares to finance their own loan portfolios
           rather than rely on outside capital. Members may benefit from higher returns on
           savings, lower rates on loans, and fewer fees on average. The National Credit Union
           Administration charters and supervises federal credit unions and insures deposits in
           federal and most state-charted credit unions through the National Credit Union Share
           Insurance Fund.9

          Thrifts, which are financial institutions that generally possess the same depository,
           credit, and account transactional functions as commercial banks. However, they are
           organized and operate primarily to promote savings and home mortgage lending as
           opposed to commercial lending. In 2011, the OCC assumed supervisory responsibility
           for federal thrifts from the now-defunct Office of Thrift Supervision. The FDIC
           insures thrift deposits.

       Mortgage Companies

Mortgage companies specialize in the origination, sale, and/or servicing of real-estate
mortgage loans. Included in this group are independent nonbank mortgage companies and
subsidiaries of commercial banks that specialize in mortgage lending. In this report we
discuss primarily the growth of and risks associated with a subset of the above—nonbank
mortgage companies that are unaffiliated with commercial banks. In general, nonbank
mortgage companies:

          Are monoline businesses that rely largely upon short-term funding sources, such as
           lines of credit from commercial banks, which may be threatened during periods of
           financial stress. Some nonbank firms also obtain funding through the issuance of
           long-term debt;

          Vary in size from small, local mortgage lenders to large, nationwide lending firms;
           and

          Are typically capitalized to a lesser extent than large commercial banks and are not
           subject to the same degree of federal regulatory oversight that chartered commercial
           banks receive.10


9
    State governments may also charter credit unions.
10
  The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 created the Consumer Financial
Protection Bureau (CFPB) and authorized it to supervise and examine compliance with consumer protection
laws by mortgage lenders, consumer and student loan providers, and certain larger nonbank market



                                       OIG  EVL-2014-010  July 17, 2014                                 10
Overview of the Enterprises’ Mortgage Sale Processes

       The Enterprises Set Loan Quality Standards for the Mortgages they Purchase from
       Lenders

Lenders, including banks and mortgage companies, must ensure that the single-family
mortgages they plan to sell to Fannie Mae and Freddie Mac meet the Enterprises’ standards.
For example, the maximum principal balance of a mortgage offered for sale to an Enterprise
may not exceed the “conforming loan limit” which, in most locations, is now $417,000.11
Moreover, the underwriting associated with such loans must meet the Enterprises’ guidelines
on matters such as a borrower’s credit score and debt-to-income ratio.12 Furthermore, lenders
are contractually required to represent and warrant to the Enterprises that, at the time of their
origination, the mortgage loans they sell to the Enterprises comply with their underwriting
standards.

       Lenders Swap their Mortgages for MBS or Sell them for Cash

Lenders with mortgage loans that meet the
Enterprises’ standards may sell them in two ways.           In a swap transaction the
First, as depicted in Figure 1A, the lender swaps the       lender exchanges mortgages
loans for Enterprise MBS backed by those same               for Enterprise MBS backed by
                                                            the same mortgages.
mortgages, which the lender then sells to investors.
Second, as depicted in Figure 1B, the lender sells the
mortgages to the Enterprise for cash, and the Enterprise securitizes the mortgages and sells the
resulting MBS to investors.13 In both cases, the mortgages end-up as part of an Enterprise
MBS, and lenders obtain cash they can use to make additional loans, thereby creating
liquidity for the housing finance market.14


participants. However, the CFPB does not conduct financial safety and soundness examinations of these
companies. See 12 U.S.C. 5514. “Larger participants of certain consumer financial product and services
markets” are defined at 12 C.F.R. Part 1090.
11
  See Federal National Mortgage Charter Act (12 U.S.C. 1717(b)(2)), the Federal Home Loan Mortgage
Corporation Act (12 U.S.C. 1454(a)(2)), and the Housing and Economic Recovery Act of 2008 (Pub. L. No.
110-289 § 1124).
12
  These underwriting standards serve to mitigate potential credit losses on the loans that comprise the MBS
guaranteed by the Enterprises. For more information on underwriting standards, see OIG, FHFA’s Oversight
of Fannie Mae’s Single-Family Underwriting Standards, at 2 (March 22, 2012) (AUD-2012-003) (online at:
www.fhfaoig.gov/Content/Files/AUD-2012-003_0.pdf).
13
     Each Enterprise may also purchase mortgage loans or MBS and hold them in its retained mortgage portfolio.
14
  As described later in this report, larger lenders generally prefer to swap their mortgages for MBS whereas
smaller lenders typically sell their mortgages to the Enterprises for cash.




                                       OIG  EVL-2014-010  July 17, 2014                                        11
                      FIGURE 1A. LENDER SWAPS MORTGAGES FOR ENTERPRISE MBS
                                 Mortgages                             Mortgages

           Homeowners                                 Lenders

                                     Cash                                  MBS
                                                MBS
                                                                Cash



                                                   Investors



                  FIGURE 1B. LENDER SELLS MORTGAGES TO AN ENTERPRISE FOR CASH

                     Mortgages                        Mortgages                        MBS

     Homeowners                       Lenders                                                       Investors

                         Cash                            Cash                           Cash


In exchange for a fee, known as “the guarantee fee,” the Enterprises guarantee that investors
will continue to receive the timely payment of principal and interest on their MBS regardless
of the credit performance of the underlying mortgages.15

      The Enterprises May Require Sellers to Repurchase Mortgages that Do Not Comply
      with their Underwriting Standards

The Enterprises have established ongoing, post-purchase quality review processes to verify
that the mortgages they purchase conform to their underwriting standards. If an Enterprise
determines that a mortgage does not conform to its underwriting standards at the time of the
loan’s origination, then the Enterprise may require the mortgage seller to repurchase the
mortgage at full face value or indemnify the Enterprise for any losses incurred.16 As shown in
Figure 2 below, since the financial crisis the Enterprises have recovered nearly $100 billion
through their assertion of repurchase claims.


15
  For more information about the Enterprises’ guarantees and the fees associated with them, see OIG, FHFA’s
Initiative to Reduce the Enterprises’ Dominant Position in the Housing Finance System by Raising Gradually
Their Guarantee Fees (July 16, 2013) (EVL-2013-005) (online at: www.fhfaoig.gov/Content/Files/EVL-2013-
005_4.pdf) (hereinafter, OIG Guarantee Fee Report).
16
  For example, a loan may not comply with the Enterprises’ underwriting standards if borrowers did not earn
the amount of income stated on their mortgage application.




                                    OIG  EVL-2014-010  July 17, 2014                                          12
                FIGURE 2. ENTERPRISE REPURCHASE REQUEST RECOVERIES, IN $ BILLIONS
                              2009        2010         2011        2012          2013          Total
             Fannie Mae       $4.6        $8.8         $11.5       $17.1         $32.2         $74.2
            Freddie Mac       $4.3        $6.4         $4.5        $3.5          $5.6          $24.3
                   Total      $8.9        $15.2        $16.0       $20.6         $37.9         $98.5

Source: Fannie Mae: Form 10-K for the Fiscal Year Ended December 31, 2010, at 172; Form 10-K for the
Fiscal Year Ended December 31, 2011, at 175; Form 10-K for the Fiscal Year Ended December 31, 2013, at
143. Freddie Mac: Form 10-K for the Fiscal Year Ended December 31, 2010, at 108, and Form 10-K for the
Fiscal Year Ended December 31, 2013, at 138. The figure may include some recoveries based upon violations
of Enterprise servicing guidelines. Numbers may not add to total shown due to rounding.

     Lenders Often Service the Mortgages They Sell to the Enterprises

Many banks and mortgage companies serve as
mortgage servicers for the loans they sell to                      On the Enterprises’ behalf, mortgage
Fannie Mae and Freddie Mac. That is, they act                      servicers collect payments from
as points of contact between borrowers and the                     borrowers; maintain escrow accounts
Enterprises that own the mortgage loans. Servicers                 for property taxes and insurance; and
                                                                   handle mortgage modifications,
typically receive a percentage of the unpaid
                                                                   defaults, and foreclosures.
principal balance (UPB) of the mortgages they
manage as a fee for their services.

Large Financial Institutions May Aggregate and Sell Smaller Lenders’ Mortgage Loans
to the Enterprises

Large commercial banks and mortgage companies may act as aggregators for smaller lenders,
i.e., smaller commercial banks, credit unions, thrifts, and mortgage companies. They do
so by purchasing mortgages originated by smaller institutions and selling the loans to the
Enterprises. Figure 3, below, depicts the relationship between loan-aggregating lenders and
smaller lenders.17 Typically, the aggregators perform the following functions:

        Verify that the loans meet the Enterprises’ underwriting standards. To do so,
         the aggregators may “re-underwrite” the mortgages; that is, they review the loan
         documentation to ensure compliance with the Enterprises’ requirements.

        Assume responsibility for the representations and warranties on the mortgage loans
         originated by smaller lenders. Accordingly, the Enterprises may seek repurchases


17
  The type of lending described in this section is commonly known as correspondent lending. Generally,
correspondent lenders complete loan processing and underwriting, fund loans in their name, and then sell
closed loans to other banks and mortgage companies, which we refer to as “aggregators.”




                                     OIG  EVL-2014-010  July 17, 2014                                     13
         directly from the aggregators for any mortgage loans originated by smaller lenders that
         do not meet their underwriting standards or other requirements.

As explained below, the role played by large institutional aggregators has diminished since
the financial crisis of 2008.

                  FIGURE 3. LOAN SALES TO THE ENTERPRISES THROUGH AGGREGATORS
                                  Mortgages                           Mortgages
               Smaller                            Aggregator
               Lenders                             Lenders
                                     Cash                               Cash or
                                                                         MBS
         Typically sell closed                Verify underwriting
          mortgage loans to                    Hold liability for
          aggregators                           mortgages sold to
                                                Enterprises

Source: OIG analysis of information provided by Fannie Mae and Freddie Mac, and Mortgage Bankers
Association, 33 Hour SAFE Comprehensive School of Mortgage Banking I, Introduction to Real Estate Finance
Industry, Book 1 (2012).

     The Aggregation System Offered Financial and Other Benefits to the Participants

The aggregation system provided financial benefits to both the aggregators and smaller
lenders. Aggregators benefitted because the Enterprises have historically provided guarantee
fee discounts to them based upon the volume of loans that they delivered. By combining their
own mortgages with those originated by smaller lenders, the aggregators received larger
guarantee fee discounts from the Enterprises.18 In turn, the aggregators passed along a portion
of their discounted guarantee fees to smaller lenders in the form of better prices than the
Enterprises could offer them. This arrangement provided many smaller lenders with financial
incentives to sell their mortgages to aggregators rather than directly to the Enterprises.

Aggregators also purchased the mortgage servicing
rights associated with the loans they bought from                        Mortgage Servicing Rights are
smaller lenders. According to representatives of                         the contractual rights to service a
Fannie Mae, this provided the primary financial                          mortgage and receive fees for
incentive for smaller lenders to participate in the                      those services. They may be
                                                                         bought and sold among servicers.
aggregation system. The mortgage servicing rights
provided the aggregators with ongoing fee income and


18
  For more information on the guarantee fees that lenders pay and the Enterprises’ historic practice of
providing volume-based discounts, see OIG Guarantee Fee Report, at 18.




                                      OIG  EVL-2014-010  July 17, 2014                                       14
the opportunity to market their other financial services directly to the mortgage borrowers
whose loans they serviced.

The Enterprises also benefitted from purchasing mortgages from aggregator sellers.
Specifically:

        The aggregators performed an additional layer of review by ensuring that mortgages
         originated by smaller lenders met the Enterprises’ underwriting standards;19

        The Enterprises did not have to track potentially hundreds of smaller lenders’ financial
         condition and compliance with their selling and servicing guidelines; and

        Large aggregators may have had more ability to honor the Enterprises’ mortgage loan
         repurchase demands because they often had greater financial resources than smaller
         lenders.

     Many Aggregators Have Failed or Withdrawn from the Business Since the Financial
     Crisis Due to Changing Economic Circumstances and Regulatory Initiatives

The role played by aggregators in the sales of mortgage loans to the Enterprises prior to the
financial crisis of 2008 was quite significant, but since then it has declined due to the failure
of some aggregators, changing economic circumstances, and new regulatory requirements.

Fannie Mae recently reported that only 5 of the top 20 mortgage originators of 2006 remain
active in the mortgage market today.20 The firms that failed or were absorbed by other
lenders include some of the Enterprises’ top sellers and aggregators. For example, according
to data obtained from Fannie Mae, Countrywide Financial, which was later purchased by
Bank of America, was responsible for nearly a third of Fannie Mae’s mortgage purchases
in the second quarter of 2007.

Moreover, during the past three years several large aggregators, including Bank of America,
have stopped purchasing mortgages originated by other lenders. Other large lenders,
including Wells Fargo and CitiMortgage, have also reduced their aggregation activities.




19
  In recent years, aggregators generally have employed stricter underwriting standards—beyond the
Enterprises’ requirements—on loans purchased from smaller lenders. This has ensured the sale of high quality
loans to the Enterprises.
20
  See Fannie Mae, Deconsolidation in the Primary Mortgage Market: A Temporary or Structural Trend?,
Fannie Mae Housing Insights, Volume 3, Issue 10, at 1 (December 5, 2013) (online at
http://www.fanniemae.com/resources/file/research/datanotes/pdf/housing-insights-120513.pdf).




                                    OIG  EVL-2014-010  July 17, 2014                                         15
Our discussions with FHFA and Enterprise officials led us to identify several apparent causes
of this trend, which are detailed below.21

          Repurchase Requests: In recent years, the largest commercial banks have been faced
           with a high volume of repurchase requests from the Enterprises for legacy mortgages
           sold to them between 2005 and 2008.22 For example, as shown in Figure 2 above, the
           Enterprises resolved $37.9 billion in outstanding repurchase requests in 2013 alone.
           Enterprise officials said that large sellers have attempted to reduce their future
           repurchase risk by limiting acquisitions of mortgages originated by other lenders
           and increasing their scrutiny of the third-party mortgages they acquire.23

          Guarantee Fee Increases: In 2012, FHFA announced an average increase of 10 basis
           points in the Enterprises’ guarantee fees. The increase was intended, in part, to reduce
           the disparity in guarantee fee pricing between large and small sellers.24 An official
           from one Enterprise said that the fee increase caused large banks to realize less
           compensation for assuming the representation and warranty liability associated with
           mortgages originated by smaller lenders.25

          New Financial Regulations: Under U.S. financial regulations instituted in the wake of
           the Basel III accord, mortgage servicing assets are treated as riskier assets that require
           the banks that hold them to have significantly higher levels of capitalization.26
           Enterprise officials said that large banks have responded to the regulations by


21
  Fannie Mae has argued that this shift is the result of the cyclical nature of the secondary market as opposed
to a structural change. See id, at 4.
22
  Repurchase requests may decline in future years. Fannie Mae reported that, as of the end of 2013, it
requested repurchases for less than 0.25% of the mortgages it acquired between 2009 and 2012. By way of
comparison, the repurchase rate for mortgages it acquired between 2005 and 2008 was 3.7%. See Fannie Mae,
Form 10-K for the Fiscal Year Ended December 31, 2013, at 143.
23
  Fannie Mae officials said that the delay in funding caused by longer underwriting review times has been one
of the factors driving smaller lenders to sell directly to the Enterprises.
24
  See FHFA, FHFA Announces Increase in Guarantee Fees (August 31, 2012) (online at
http://www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Announces-Increase-in-Guarantee-Fees.aspx).
25
     Officials from the other Enterprise discounted this explanation and cited other factors.
26
  The Federal Reserve System, the OCC, and the FDIC issued rules in 2013 that overhauled the regulatory
capital framework of the U.S. banking sector. Under the U.S.’s implementation of Basel III, mortgage
servicing assets that exceed 10% of a bank’s common equity tier 1 capital will now be deducted from the
bank’s regulatory capital; and mortgage servicing assets held below the 10% threshold will be treated with a
100% risk weight, which will increase to a 250% risk weight by 2018. In addition, the combined holding of
mortgage servicing assets, tax deferred assets, and certain other investments are limited to 15% of regulatory
capital. These capital requirements went into effect for large financial institutions on January 1, 2014, and will
go into effect for smaller banks in 2015.




                                         OIG  EVL-2014-010  July 17, 2014                                          16
        prioritizing lending through their own mortgage origination operations over
        purchasing mortgages from third parties.27

Smaller Lenders and Nonbank Mortgage Companies Have Increased Their Direct Sales
of Mortgages to the Enterprises

Since 2011, smaller lenders, including smaller commercial banks, credit unions, thrifts, and
mortgage companies, have increased dramatically their sales of mortgages to the Enterprises.
FHFA and Enterprise officials told us that this trend is due, in part, to the fact that some large
financial institutions no longer act as aggregators for the smaller lenders. Several of the larger
financial institutions have failed, and others have reduced their aggregation of third-party
originated loans. Smaller lenders have applied in increasing numbers to become Enterprise
sellers in order to continue selling their mortgages into the secondary market.

In the aggregate, nonbank mortgage companies have increased their sales to the Enterprises.
According to Enterprise officials, they have done so, in part, by expanding their operations
more aggressively than commercial banks in response to the recent boom in residential
mortgage refinancing. Recently, nonbank specialty servicers have also begun originating
mortgages and selling them to the Enterprises.

     The Number of Active Seller Counterparties Has Increased at Both Enterprises

As shown in Figure 4 below, the Enterprises have seen a steady increase in their active
mortgage seller counterparties since the 2007 to 2008 financial crisis.28 For example, between
the first quarter of 2011 and the third quarter of 2013, Fannie Mae’s total seller count
increased by 14%, and Freddie Mac’s increased by 7%. Moreover, between late 2007 and
late 2013 the number of each Enterprise’s active mortgage sellers grew by an average of about
30%.




27
  Large commercial banks have also sold significant amounts of their mortgage servicing assets, also known
as mortgage servicing rights, to nonbank servicers. The nonbank servicers are not covered by the Basel III
regulations. For more information on this trend, see Financial Stability Oversight Council, 2014 Annual
Report, at 54 (accessed May 12, 2014) (online at:
http://www.treasury.gov/initiatives/fsoc/Documents/FSOC%202014%20Annual%20Report.pdf).
28
  Much of the analysis in this report section was informed by an internal FHFA presentation on risks presented
by nonbanks and smaller lenders, which is discussed later in this report. However, our analysis uses a separate
data set independently requested from the Enterprises. The data extend back 10 years to 2003 and present
information on lenders who sold conventional single-family mortgage loans to the Enterprises.




                                     OIG  EVL-2014-010  July 17, 2014                                           17
          FIGURE 4. QUARTERLY NUMBER OF ACTIVE SINGLE-FAMILY SELLER COUNTERPARTIES
                                    (2003 Q1 – 2013 Q3)
               1,200
                               Fannie Mae          Freddie Mac

               1,100


               1,000


                 900


                 800


                 700
                    2003    2004   2005     2006   2007   2008   2009    2010    2011   2012    2013

Source: OIG analysis of data provided by Fannie Mae and Freddie Mac. The chart presents a total count of all
counterparties that sold conventional single-family mortgage loans to the Enterprises in each quarter.


     The Market Share of the Enterprises’ Largest Mortgage Sellers Has Declined
     Significantly

The decline in market share among the Enterprises’ respective top five sellers provides
evidence of the shift in the composition of their mortgage seller counterparties. In early 2011,
their top five sellers delivered between 65% and 70% of the mortgages purchased by each
Enterprise.29 Since then, there has been a pronounced decline in the market share of the
Enterprises’ largest mortgage seller counterparties. As depicted in Figure 5 below, this has
resulted in the top five sellers contributing less than half of the Enterprises’ mortgages by the
third quarter of 2013.




29
  For most top sellers to the Enterprises, loans originated by other lenders, e.g., correspondent lenders, made
up a significant portion of their sales volume. For example, according to data collected by the trade
publication Inside Mortgage Finance, in the fourth quarter of 2011, for the top five sellers to both Enterprises,
the share of mortgages originated by correspondent lenders ranged between 33% and 74% of their total
mortgage deliveries. See Inside Mortgage Finance, 2012 Mortgage Annual Statistical, “GSE Business Profile
of Top Mortgage Sellers in 4Q11.”




                                      OIG  EVL-2014-010  July 17, 2014                                            18
     FIGURE 5. MARKET SHARE OF THE ENTERPRISES’ TOP-FIVE SELLERS, BY UPB (2003 Q1 – 2013 Q3)
              85%
                                                               Fannie Mae             Freddie Mac
              80%
              75%
              70%
              65%
              60%
              55%
              50%
              45%
              40%
              35%
                 2003    2004    2005     2006   2007   2008   2009    2010    2011    2012    2013

Source: OIG analysis of data provided by Fannie Mae and Freddie Mac.

The Enterprises’ mid-tier and                     FIGURE 6. MARKET SHARE OF MORTGAGE SALES TO THE
smallest sellers have gained the                  ENTERPRISES BY SELLER SALES VOLUME
market share ceded by the largest
                                                                 Fannie Mae              Freddie Mac
mortgage sellers. Figure 6, right,                          2011 Q1      2013 Q3     2011 Q1     2013 Q3
illustrates this trend through           Sellers 1-5          65%          45%         70%         44%
snapshots of mortgage sales to the
                                         Sellers 6-50         27%          33%         24%         43%
Enterprises in the first quarter of
2011 and the third quarter of 2013.      Sellers 51-900+       8%          22%          5%         13%
While both Enterprises saw a decline
in sales from their top five sellers,     Source: OIG analysis of data provided by Fannie Mae and
                                          Freddie Mac.
different segments of their mortgage
sellers benefited most from this trend. At Fannie Mae, the smallest sellers—those outside the
top 50—gained the most market share, increasing from 8% to 22%, while mid-tier sellers
gained the most ground at Freddie Mac, expanding market share from 24% to 43%.

Significant Increase in Mortgage Lender Cash Sales to the Enterprises

As discussed previously, lenders may either swap their mortgages for MBS or sell them to
the Enterprises for cash. Traditionally, smaller lenders have sold their mortgages to the
Enterprises for cash because such sales are less operationally challenging than MBS swaps.30

30
  Fannie Mae officials told us that cash window sales require less loan volume; pay sellers relatively quickly;
and have a wider tolerance for loan credit characteristics relative to MBS deliveries.




                                        OIG  EVL-2014-010  July 17, 2014                                        19
With smaller lenders contributing a bigger portion of the Enterprises’ mortgages, it is not
surprising that the market share of cash-window sales has increased significantly over the past
few years. As shown in Figure 7 below, cash window sales grew to between 20% and 25% of
each Enterprise’s total mortgage purchase volume by late 2013. Enterprise data indicate that
Fannie Mae’s cash window sales have increased at a faster rate than Freddie Mac’s cash
sales.31

                FIGURE 7. MARKET SHARE OF CASH WINDOW SALES TO THE ENTERPRISES,
                                   BY UPB (2003 Q1 – 2013 Q3)
             35%
                             Fannie Mae          Freddie Mac
             30%

             25%

             20%

             15%

             10%

               5%

               0%
                 2003    2004    2005     2006   2007   2008   2009    2010    2011   2012    2013

Source: OIG analysis of data provided by Fannie Mae and Freddie Mac.

     Increased Sales Percentages from Nonbank Mortgage Companies

Enterprise data also indicate that sales from nonbank mortgage companies, i.e., those
unaffiliated with commercial banks, represent a growing percentage of their mortgage
purchases.32 According to a Fannie Mae document, 46.6% of its mortgages were purchased


A Fannie Mae official also suggested that even large banks may rely on cash windows more now due to the
simplicity of the cost structure and shortened time delays for cash window sales. However, we were unable to
confirm this from the data provided by the Enterprises.
31
   In the first quarter of 2011, cash window sales to Fannie Mae and Freddie Mac amounted to $16.3 billion
and $10.8 billion, respectively. By the third quarter of 2013, cash window sales had increased to $44.5 billion
at Fannie Mae and $18.8 billion at Freddie Mac.
32
   Nonbank lenders have increased their share of overall mortgage originations. Inside Mortgage Finance
recently estimated that nonbank lenders accounted for 37.7% of mortgage originations in the first quarter of
2014, which was up from 26% in the same quarter of the prior year. See John Bancroft, Nonbanks Continue to
Gain Production Share; Biggest Losers Among the Top 30: Fifth Third, Citi, IMF news (May 1, 2014) (online
at: http://www.insidemortgagefinance.com/imfnews/1_343/daily/nonbank-mortgage-lenders-continue-to-gain-
market-share-1000027109-1.html).




                                        OIG  EVL-2014-010  July 17, 2014                                        20
from nonbank mortgage companies in the first three quarters of 2013, which was up from
33.2% in 2011. Freddie Mac data shows that its share of mortage purchases from nonbank
mortgage companies more than doubled from 8.4% to 20.5% over that same period, but its
share remains significantly lower than Fannie Mae’s share.

As depicted in Figure 8 below, this trend is particularly prevalent among Fannie Mae’s largest
mortgage sellers. Sales from nonbank mortgage companies within Fannie Mae’s top ten
sellers more than doubled between the first quarter of 2011 and the third quarter of 2013,
rising from $11 billion to $29 billion, as measured in UPB, and representing almost 30% of
the mortgage deliveries made by that group.33

        FIGURE 8. MORTGAGE SALES BY FANNIE MAE’S TOP 10 SELLERS (2011 Q1 AND 2013 Q3),
                                      UPB IN $ BILLIONS

                              2011 Q1                                          2013 Q3

                             9%
                             $11
                                                                         29%
                                                                         $29


                                                                                         71%
                                   91%                                                   $72
                                   $115




                       Commercial Banks and Subsidiaries          Nonbank Mortgage Companies

Source: OIG analysis of data provided by Fannie Mae.

Apart from the decline in mortgage aggregation among the top sellers, FHFA and Enterprise
officials generally attributed the increase in direct sales from nonbank mortgage companies to
the refinance boom of 2012 and early 2013. The record low interest rates during that period
provided an incentive for many homeowners to reduce their interest rates by refinancing their
mortgages. During this period the lending industry sometimes lacked the capacity to meet the
refinancing demand. This, in turn, caused many nonbank mortgage companies to quickly
expand their operations. Additionally, new lenders formed what FHFA and Enterprise
officials have termed “niche” refinance companies.
33
  Freddie Mac saw similar, but less pronounced, gains by nonbank mortgage companies among its top ten
mortgage sellers during this period. Such lenders provided 3% ($2.4 billion in UPB) of the mortgages sold by
Freddie Mac’s top ten sellers in the first quarter of 2011 and 11% ($6.5 billion in UPB) in the third quarter of
2013.




                                      OIG  EVL-2014-010  July 17, 2014                                           21
     Nonbank Specialty Servicers Have Initiated Mortgage Sales to the Enterprises

The Enterprises have experienced significant growth
in mortgage sales from nonbank companies commonly               Specialty servicers, also known
referred to as specialty servicers. According to                as high-touch servicers, are
FHFA and Enterprise officials, specialty servicers              nonbank firms that specialize in
grew in the wake of the housing crisis. They did so,            servicing troubled loans.
in part, by acquiring the mortgage servicing rights to
large banks’ portfolios of troubled mortgage loans, including loans that were serviced on
behalf of the Enterprises.34 The officials said that specialty servicers entered into mortgage
lending to recapture business from distressed borrowers who were newly able to refinance
into more affordable mortgages in the low-rate environment.35

Some of these nonbank specialty servicers are now among the Enterprises’ fastest growing
mortgage sellers due, in part, to their attempts to provide refinance loans to distressed
borrowers. According to data obtained from the Enterprises:

        Mortgage sales from Nationstar Mortgage and its parent company, Fortress Investment
         Group, grew from $441.7 million in the first quarter of 2011 to $7.7 billion in the third
         quarter of 2013. Fortress Investment Group was the sixth largest seller to Fannie Mae
         in the third quarter of 2013, and Nationstar Mortgage was the ninth largest seller to
         Freddie Mac that quarter.

        Walter Investment Management Corporation, the parent company of specialty servicer
         Green Tree Servicing, initiated mortgage sales to Fannie Mae in the fourth quarter of
         2012. Its mortgage sales to Fannie Mae grew from just $15.4 million in the fourth




34
  In the past, the Enterprises have encouraged sales of mortgage servicing rights from large commercial banks
to specialty servicers because their business model involved closer and more frequent contact with distressed
borrowers that resulted generally in better outcomes for borrowers and creditors. For more information see
OIG, Evaluation of FHFA’s Oversight of Fannie Mae’s Transfer of Mortgage Servicing Rights from Bank of
America to High Touch Servicers (September 18, 2012) (EVL-2012-008) (online at
http://www.fhfaoig.gov/Content/Files/EVL-2012-008.pdf).
According to Enterprise officials, a number of the large servicing portfolios acquired by specialty servicers
from banks were acquired without the selling representations and warranties, indicating the higher-capitalized,
regulated depository institutions often retained the repurchase risk on the loans.
35
  An FHFA official also said that rising home prices and the shrinking population of homeowners with
seriously delinquent mortgages has contributed to specialty servicers initiating or acquiring their own mortgage
origination operations.




                                     OIG  EVL-2014-010  July 17, 2014                                            22
         quarter of 2012 to $6.3 billion in the third quarter of 2013, making the firm Fannie
         Mae’s fifth largest seller that quarter.36

Risks and Challenges Associated with the Increase in Mortgage Sales by Smaller
Lenders and Nonbank Mortgage Companies

The increase in mortgage sales to the Enterprises by smaller lenders and nonbank mortgage
companies presents the Enterprises with certain potential benefits, such as a reduction in their
high concentration risk—a product of their financial exposure to a few large commercial
banks. Enterprise officials also said that purchasing mortgages from smaller lenders and
nonbank mortgage companies helps them to provide liquidity to the secondary mortgage
market.

However, we have identified new risks and challenges associated with the shift in the
composition of lenders that sell mortgages to the Enterprises. Specifically, and as described
below, the trend towards smaller sellers and nonbank mortgage companies may present the
Enterprises with elevated credit, operational, and reputational risks.37 Our conclusion in this
regard is based upon our discussions with FHFA and Enterprise officials, as well as our
review of their records and other relevant documents.

     Elevated Counterparty Credit Risks

The Enterprises’ increase in mortgage purchases from smaller lenders and nonbank mortgage
sellers may elevate their exposure to counterparty credit risk—the risk that a counterparty will
default on financial obligations to the Enterprises, e.g., their representation and warranty
obligations.38 The Enterprises’ traditional top sellers—large commercial banks—are
36
  Mortgage sales to the Enterprises from Fortress Investment Group and Walter Investment Management may
include acquisitions from other subsidiaries aside from Nationstar Mortgage and Green Tree Servicing. In
addition, Walter Investment Management saw its volume of mortgage sales increase after acquiring an existing
mortgage-lending platform in early 2013.
37
 These risks are not mutually exclusive. For example, a counterparty that represents high reputational risk
may also present heightened credit and operational risks.
38
   Our report is not intended to suggest that, as a class, small or nonbank lenders pose higher credit risks to the
Enterprises. Indeed, community banks, for example, may originate mortgages with lower default and other
risks than larger institutions. Our intent is to represent what FHFA and the Enterprises have identified as risks
associated with some smaller lenders and nonbank mortgage companies.
For example, Fannie Mae’s regulatory filings indicate that the decrease of its concentration with large
depository institutions may increase its counterparty credit risk and mortgage credit risk, and may have an
adverse effect on its financial condition. The Enterprise further disclosed that the smaller and nonbank
counterparties with which is it conducting a greater proportion of business may lack the same financial
strength, liquidity, or operating capacity as larger depository institutions. See Fannie Mae, Form 10-K for the
Fiscal Year Ended December 31, 2013, at 38, 54 (February 21, 2014) (online at
http://www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2013/10k_2013.pdf).




                                       OIG  EVL-2014-010  July 17, 2014                                             23
generally well-capitalized financial firms that benefit from broad access to funding and
maintain diversified business lines. Their financial strength has allowed such counterparties
to fulfill their responsibilities for Enterprise mortgage repurchase requests. Furthermore, the
Federal Reserve, OCC, and FDIC enforce prudential standards for capital and liquidity at
commercial banks and oversee their financial safety and soundness by examining their
operations.39

In contrast, some smaller and nonbank lenders have relatively limited financial capacity, and
the latter are not subject to federal safety and soundness oversight.40 According to FHFA
officials and records, some of the Enterprises’ emerging sellers may not have the financial
capacity necessary to honor their representation and warranty commitments on the mortgages
they sell to the Enterprises.41 Consequently, the Enterprises could incur financial losses on
mortgages purchased from such lenders if they do not comply with established underwriting
guidelines.42



39
  We observe that federal financial regulators did not always effectively supervise large commercial bank and
other financial institution risk management practices during the housing boom of 2005 through 2007. Thus,
federal supervision unto itself does not necessarily mitigate the Enterprises’ credit risks from counterparties.
40
   As noted above, the CFPB may supervise and examine mortgage companies’ compliance with consumer
protection laws. However, a senior FHFA official said that this level of review was not equivalent to the
financial safety and soundness oversight performed by other federal regulators.
In its 2014 Annual Report, the Financial Stability Oversight Council (FSOC) observed that state financial
regulators provide some oversight of nonbank servicers, including the imposition of bonding and minimum net
worth requirements. However, many nonbank servicers are not subject to prudential standards, such as those
associated with capital, liquidity, and risk management oversight. FSOC also recommended that state
regulators collaborate with the CFPB and FHFA to establish prudential and governance standards for nonbank
servicers. See FSOC, 2014 Annual Report, at 10, 114 (accessed May 12, 2014) (online at:
http://www.treasury.gov/initiatives/fsoc/Documents/FSOC%202014%20Annual%20Report.pdf).
41
  According to Freddie Mac officials, smaller sellers frequently provide credit enhancements, such as
collateral, against representations and warranties exposures. These enhancements partially offset the risks and
uncertainties that the Enterprises take on when doing business with them.
In addition, the Enterprises revised their representation and warranty frameworks effective January 1, 2013.
These revisions may reduce the magnitude of claims made against lender counterparties. In general, the
Enterprises will not pursue repurchase requests for mortgages on which the borrower remained current in
payments for the first 36 months of the loan, with certain exceptions, such as if the mortgage does not comply
with laws or contains misstatements or omissions and data inaccuracies. In conjunction with the new
framework, the Enterprises announced expansions of their quality control and enforcement processes for
recently purchased loans. Enterprise officials project that these changes will reduce the number of future
repurchases.
42
  The high quality of the loans delivered to the Enterprises in recent years mitigates some of the counterparty
credit risks presented by emerging sellers. High quality mortgage loans carry a lower probability of borrower
default and are less likely to result in repurchase requests. So long as the purchased mortgages maintain low
default rates, the Enterprises have the performance and collateral of the mortgages as their first line of defense
against credit losses.




                                      OIG  EVL-2014-010  July 17, 2014                                             24
Recent market trends already raise questions about the long-term viability of some of the
Enterprises’ seller counterparties. The refinancing boom that spurred the growth of many
lenders began to recede in 2013 when mortgage rates rose from record low positions. As
depicted in Figure 9 below, mortgage refinances are estimated to have fallen by over 75%
since their peak in the fourth quarter of 2012. The corresponding reduction in business has
hurt mortgage company profits and resulted in lay-offs across the sector.43

      FIGURE 9. QUARTERLY ESTIMATED SINGLE-FAMILY MORTGAGE ORIGINATION VOLUMES AND
           MONTHLY AVERAGE COMMITMENT RATES ON 30-YEAR FIXED-RATE MORTGAGES
                                               $600                                                                              5.0
               Origination Volume (Billions)




                                               $500




                                                                                                                                       Interest Rate (Percent)
                                                                                                                                 4.5
                                               $400

                                               $300                                                                              4.0

                                               $200
                                                                                                                                 3.5
                                               $100

                                                 $0                                                                              3.0
                                                      2011               2012                     2013                 2014

                                                        Home Purchases          Home Refinances          Mortgage Rate (Right)


Source: Mortgage Bankers Association Quarterly Mortgage Originations Estimates as of May 2014 and the
Freddie Mac Primary Mortgage Market Survey, historical monthly data for conventional, conforming 30-year
fixed-rate mortgages.




In addition, officials from the Enterprises told us that the relatively low, though growing, levels of mortgage
loan deliveries from smaller sellers mitigate their counterparty credit risks due to the relatively small degree of
financial exposure to any one of these counterparties. For example, 96% of Freddie Mac’s projected potential
losses from counterparties during a stress event come from its top 200 counterparties. We note that many
nonbank mortgage companies are among the Enterprise’s top sellers.
43
  The Mortgage Bankers Association reported that, in the fourth quarter of 2013, mortgage company
origination profits were at their lowest level, and production expenses were at their highest level, since it began
surveying mortgage companies in 2008. See Mortgage Bankers Association, Independent Mortgage Banker
Profits Reach New Lows in the Fourth Quarter of 2013 (March 26, 2014) (online at:
http://www.mba.org/NewsandMedia/PressCenter/87759.htm).




                                                                OIG  EVL-2014-010  July 17, 2014                                                               25
     Elevated Operational Risks

The increasing trend of smaller and nonbank
mortgage lenders selling loans directly to the           Operational risk is the exposure
Enterprises may also present heightened                  to loss from inadequate or failed
operational risks. One Enterprise official told          internal processes, people, and
                                                         systems, or from external events,
us that, relative to large commercial banks, the
                                                         including legal events.
operations of some smaller lenders may lack
sophistication, resulting in potential quality
control and fraud management problems. For example, small lenders may lack access to
experts in increasingly complex subject areas, such as regulatory compliance.

FHFA officials also told us that the rapidity that characterizes the specialty servicers’
mortgage origination and sales business growth also presents increased operational risks for
the Enterprises. Specifically, the officials said that the increased pace of the specialty
servicers’ business could cause them to stretch their operational capacity or overrun their
quality control procedures. We observe that this, in turn, could increase the potential for
representation and warranty claims and credit losses on the mortgages they sell to the
Enterprises. We have reported on problems that the Enterprises discovered in the servicing
operations of a specialty servicer and the need for increased oversight.44 Similar oversight is
needed with respect to the operations by which the Enterprises’ specialty servicers originate
residential mortgages.

Finally, we note that the change in the composition of the Enterprises’ mortgage sellers may
increase the Enterprises’ operational risks and costs. Specifically, and as detailed in the next
section of this report, 45 the change requires the Enterprises to monitor the financial strength
and operational capacity of their many new lenders and nonbank mortgage companies as well
as that of their traditional large bank sellers. This, in turn, requires the Enterprises to expend
additional resources to develop the added operational capacity necessary for this task.

     Elevated Reputational Risk

According to FHFA, Enterprise officials, and the documents that we have obtained, buying
loans from some nonbanks could damage the Enterprises’ reputations.46 This could occur if,
44
  See, OIG, FHFA Actions to Manage Enterprise Risks from Nonbank Servicers Specializing in Troubled
Mortgages, at 7-8 (AUD-2014-014, July 1, 2014) (online at: http://www.fhfaoig.gov/Content/Files/AUD-2014-
014.pdf).
45
   The next report section summarizes some of the controls that the Enterprises have established to mitigate the
risks associated with the change in the composition of their mortgage sellers.
46
  We observe that reputational risk is not confined to, for example, some nonbank mortgage companies.
Several large commercial bank counterparties of the Enterprises, such as Bank of America and JPMorgan



                                     OIG  EVL-2014-010  July 17, 2014                                            26
for example, an Enterprise bought loans from a lender that harmed consumers by engaging
in fraud or other misconduct.47 Moreover, the Enterprises’ reputations could be damaged if
several of these entities failed while the Enterprises had financial exposure to them, as could
occur under adverse market conditions.

FHFA identified a nonbank lender that exemplifies the reputational risks discussed above.
This particular lender became a top 20 seller to one Enterprise during the refinance boom of
2012 to 2013. In 2013, one of the lender’s businesses engaged in abusive lending practices
causing it to be subjected to regulatory and enforcement actions by several state authorities.48
Representatives of the affected Enterprise told us that it assessed the lender’s mortgage-
lending operations during the period of its rapid growth.49 In the third quarter of 2013, the
Enterprise became increasingly concerned with the heightened reputational risk caused by the
regulatory enforcement actions and civil litigation that had been filed against the lender and
accepted the lender’s voluntary suspension from doing further business with the Enterprise.50

The Risk Management Controls Put in Place by the Enterprises to Address the Increase
in Direct Sales from Smaller Lenders and Nonbank Mortgage Lenders

Fannie Mae and Freddie Mac officials told us that the Enterprises have modified their existing
counterparty risk management controls in response to increased direct mortgage sales from
smaller and nonbank lenders. According to these officials and documents that we have
reviewed, some of their modified risk management controls include:51




Chase, have reached significant financial settlements with the Department of Justice, federal regulators, and
states’ Attorneys General for misrepresenting the risks associated with mortgage securities and poor mortgage
servicing, among other deficiencies and violations.
47
  A senior FHFA examiner said that nonbank lenders can pose relatively greater reputational risks to the
Enterprises than traditional banks. The examiner said that this is due to the lack of federal oversight of
nonbank lenders and lower barriers to entry into the business relative to the chartering process for banks.
48
     The business engaged in consumer lending.
49
  Specifically, the Enterprise conducted operational and loan file reviews as well as other ongoing monitoring
activities. It also lowered the lender’s mortgage loan delivery limit and required it to post collateral against
potential future losses from representation and warranty risks.
50
  The lender sold a nominal amount of mortgage loans to the other Enterprise during 2013. An onsite
operational review by that Enterprise found deficiencies in the lender’s processes for fraud prevention and
quality control. It terminated its relationship with the lender in 2013.
51
  We did not independently verify the Enterprises’ claims about the reported improvements in their risk
management practices. We observe that the Agency is directly responsible for assessing these controls, and its
efforts in this regard are discussed in the final section of this report.




                                      OIG  EVL-2014-010  July 17, 2014                                           27
        Additional and Stricter Financial Requirements for New Mortgage Seller
         Applicants:52 The Enterprises have strengthened their financial standards for potential
         counterparties by increasing the minimum net worth requirement from $250,000 to
         $2.5 million. New applicants must undergo financial assessments and key personnel
         background checks prior to approval. Additionally, the Enterprises recently instituted
         onsite operational reviews of new nonbank seller applicants that are intended to allow
         the Enterprises to assess whether nonbank lenders possess the systems and controls
         necessary to comply with the Enterprises’ seller/servicer guides.53

        Limits on Mortgage Sales from Sellers that May Represent Elevated Risks:54
         Fannie Mae officials told us that they have instituted restrictive loan delivery limits for
         new and smaller sellers, i.e., limits on the notional dollar value of monthly or annual
         loan sales. Fannie Mae staff members can assign such delivery limits to existing seller
         counterparties in response to rapid growth, concerns about performance, or operational
         deficiencies.55 Freddie Mac officials said that the Enterprise has established internal
         risk-based exposure limits for its counterparties. However, the Enterprise has not
         established stated delivery limits for new mortgage sellers as Fannie Mae has done.

        Operational Reviews for Current Mortgage Sellers: Teams from each Enterprise are
         to perform on-site and off-site reviews to identify their current sellers’ operational
         risks, including assessments of the effectiveness of their controls and compliance with
         Enterprise requirements.56 Further, a Freddie Mac official said that in 2013 the

52
 The Enterprises’ counterparty application process seeks to ensure that potential sellers have the financial,
management, and operational readiness required to be effective counterparties.
53
  Representatives from one Enterprise said that it initiated onsite reviews of nonbank mortgage company
applicants due, in part, to the lack of federal safety and soundness oversight of such lenders.
54
   Additionally, the Boards of Directors of the Enterprises approve absolute limits on the amount of financial
exposure that they may have to counterparties. Within these absolute limits, their Enterprise Risk Management
groups administer internal operating limits that are set in accordance with their counterparties’
creditworthiness, net worth, and pledges of collateral, among other factors. Finally, Fannie Mae enforces
limits on the notional value of mortgage sales from new sellers and certain existing counterparties, as described
in the text above.
55
   In 2012, Fannie Mae began monitoring mortgage deliveries on a monthly basis, searching for lender volume
spikes, increases in third-party origination volumes, and new deliveries from dormant lenders. According to
Fannie Mae documents, identifying such lenders can lead to further review of their operations, controls, and
loan quality. A Freddie Mac Enterprise Risk Management official told us that the Enterprise does not monitor
its exposures to the mortgage loans that lenders deliver through its cash window. The official said that such
monitoring would soon be in place under a new risk management system.
56
  Fannie Mae’s operational risk review team is known as the Mortgage Origination Risk Assessment team and
Freddie Mac’s is referred to as the Counterparty Operational Risk Evaluation team.
Enterprise officials and documents indicate that, in general, the teams prioritize operational reviews according
to the degree of financial exposure that the Enterprises have to particular counterparties. Further, the
operations of the largest counterparties are reviewed on site at least once annually. The Enterprises also



                                      OIG  EVL-2014-010  July 17, 2014                                            28
        Enterprise initiated a pilot project intended to assess how well its nonbank
        counterparties would weather the decline in refinance business. The official also told
        us that Freddie Mac would conduct bi-monthly operational reviews of certain top
        specialty servicers in 2014. Fannie Mae documents indicate that the Enterprise is
        supposed to conduct operational reviews once counterparties reach a certain mortgage
        loan delivery threshold.

FHFA’s Oversight of the Enterprises’ Risk Management Controls for Mortgage Sales
from Smaller Lenders and Nonbank Mortgage Companies

FHFA examination officials stated, and Agency documents confirm, that since at least 2012
the Agency has been aware of the risks associated with increasing sales to the Enterprises by
smaller lenders and nonbank mortgage companies. In June 2013, FHFA’s Division of
Housing Mission and Goals (DHMG) completed an analysis of mortgage sellers that
highlighted the growth of nonbank sellers, the changing nature of the Enterprises’
counterparty risk, and the reputational risk associated with the nonbank lender discussed
earlier in this report.57

Our work reveals that, although the Agency conducted examinations pertaining to general
counterparty credit risk management and specialized nonbank servicers in 2013, its examiners
did not specifically test and validate the Enterprises’ controls over the risks associated with
direct mortgage sales from small lenders and nonbank mortgage companies. We note that,
according to the Agency’s 2014 planning documents, it plans to conduct several examinations
of the Enterprises’ management of the risks associated with their smaller lenders and nonbank
mortgage companies. Further, FHFA officials said that the Agency is developing guidance
intended to strengthen the Enterprises’ counterparty risk management.

     FHFA’s Examiners Assessed the Enterprises’ General Counterparty and Specialized
     Mortgage Servicer Risk Management in 2013, but Did Not Focus on their Controls for
     Smaller and Nonbank Lenders

In 2013, Division of Enterprise Regulation (DER) and Division of Supervision Policy and
Support (DSPS) examination teams initiated Enterprise counterparty credit risk examinations,


schedule examinations of counterparty operations based on key risk indicators, such as rapid growth or
referrals from other business units.
57
   DHMG is responsible for the oversight of the housing mission of the entities regulated by FHFA. DHMG’s
Office of Financial Analysis, Modeling and Simulations (OFAMS) is responsible for offsite monitoring of
financial performance and risk exposure for all the entities regulated by FHFA. OFAMS assesses the
Enterprises’ counterparty risk exposure by completing routine, standard reports and periodic in-depth
presentations.




                                     OIG  EVL-2014-010  July 17, 2014                                     29
as well as examinations of specialty servicers. The following summarizes some of these
examination activities:

        One DER core team conducted a high-level examination of an Enterprise’s
         governance of its counterparty credit risk management practices. The examination,
         which was completed in May 2014, resulted in supervisory directives to the Enterprise
         to correct certain risk management deficiencies;

        DSPS’s Office of the Chief Accountant (OCA) completed a review of the process by
         which the other Enterprise analyzed the counterparty credit risks associated with its
         mortgage insurer and seller/servicer counterparties; and

        DER conducted examination activities pertaining to the Enterprises’ management
         of operational and other risks associated with specialized mortgage servicers, which
         were discussed earlier in the report. For example, DER core team members conducted
         on-site inspections of multiple specialty servicers. DER also issued several
         recommendations to the Enterprises to strengthen their risk management controls
         for these companies’ mortgage servicing operations.58

Thus, as stated above, we determined that in 2013, the Agency did not specifically test and
validate the Enterprises’ controls over the risks associated with the recent shift in direct
mortgage sales by smaller and nonbank lenders. For example, the examiners did not validate
the effectiveness of the Enterprises’ operational reviews of new and current mortgage
sellers.59

     DER Plans to Conduct Examination Activities in 2014

DER planning materials for 2014 indicate that the Enterprises’ controls for smaller and
nonbank sellers will be a focus of the core teams’ examination activities.60 Indeed, one of
58
  Our review indicates that FHFA examination activities focused largely on the Enterprises’ risk management
controls over the mortgage servicing aspects of these companies. However, on the basis of one such review,
DER examiners recommended that an Enterprise ensure that it has plans in place to manage the risks
associated with specialty servicers that are expanding into mortgage originations. Based on our review of
Agency documentation and discussions with examiners, we concluded that DER did not specifically test and
validate the Enterprise’s existing controls, which are described, in part, earlier in this report.
59
  The 2013 DHMG presentation identified the Enterprises’ operational reviews as a control meriting
supervisory attention.
60
   DER’s 2014 examination activities are not within the scope of this report, and many were pending
completion at the conclusion of our fieldwork. However, we have previously cited concerns about FHFA’s
capacity to fulfill its annual Enterprise examination plans. See, OIG, Update on FHFA’s Efforts to Strengthen
its Capacity to Examine the Enterprises (December 19, 2013) (EVL-2014-002) (online at:
http://www.fhfaoig.gov/Content/Files/EVL-2014-002.pdf). We continue to conduct evaluations in this
important area.




                                     OIG  EVL-2014-010  July 17, 2014                                         30
DER’s four key supervisory priorities includes an assessment of the possible effects of “the
increased presence of nonbank and nontraditional seller/servicers” on the Enterprises’
business activities.

The following summarizes these planned core team examination activities:

        One core team’s planned activities include assessments of the Enterprise’s mortgage
         loan delivery limits and lender eligibility standards.

        The other core team plans to follow up on the OCA special project on the Enterprise’s
         counterparty risk analysis. Its 2014 examination plan for the Enterprise includes
         assessment of the counterparty approval process and counterparty credit risk resulting
         from cash window originations.

     DSPS Has Issued, and Is Developing, Guidance for the Enterprises on Counterparty
     Risk Management

In addition to assisting with supervision and examination of the Enterprises in 2013, DSPS
staff issued supervisory guidance to the Enterprises on counterparty credit risk management.
DSPS released what is known as an advisory bulletin recommending that Fannie Mae,
Freddie Mac, and the Federal Home Loan Banks identify high-risk and high-volume
counterparties based on internal exposure limits, and produce written contingency plans for
those counterparties in the event that internal limits are breached.61 The advisory bulletin
provided additional guidance on effective counterparty risk management under the Agency’s
Prudential Management and Operating Standards.

A DSPS manager told us that the Division plans to issue several related advisory bulletins on
counterparty risk management in 2014. The manager said that one of the bulletins would
likely focus on risk management and the approval process for seller counterparties.




61
  See FHFA, Advisory Bulletin AB 2013-01 “Contingency Planning for High-Risk or High-Volume
Counterparties” (April 1, 2013) (online at:
http://www.fhfa.gov/SupervisionRegulation/AdvisoryBulletins/AdvisoryBulletinDocuments/20130401_AB_2
013-01_Contingency-Planning-for-High-Risk-or-High-Volume-Counterparties_508.pdf).
The Advisory Bulletin states that examiners will review the Enterprises’ “policies, procedures and practices
related to credit and counterparty risk management, including [their] contingency plans for high-risk and high-
volume counterparties.” We observe that both DER core teams include examination activities related to
contingency planning in their 2014 examination plans.




                                     OIG  EVL-2014-010  July 17, 2014                                           31
CONCLUSIONS ..........................................................................

The recent shift in direct mortgage sales by smaller and nonbank mortgage company lenders
reduces the Enterprises’ concentration risks. However, the trend appears to increase other
Enterprise risks, particularly counterparty credit risk. Specifically, some of the new sellers
have limited financial capacity relative to the Enterprises’ traditional large bank
counterparties, and they are subject to less regulatory oversight. Consequently, some of the
new sellers, particularly nonbank mortgage companies, may lack the capacity to honor their
representation and warranty commitments to the Enterprises. As a result, the Enterprises
could incur financial losses on mortgages purchased from such lenders if they do not comply
with established underwriting guidelines.

The Enterprises have reportedly taken a number of steps recently to mitigate these risks.
However, due to other examination priorities, FHFA did not specifically test and validate their
effectiveness during its 2013 examination activities. The Agency has scheduled a number of
relevant examination activities during its 2014 examination cycle, and it plans to issue related
guidance on risk management practices. We will continue monitoring the effectiveness of the
Agency’s efforts to oversee this critical issue.




                               OIG  EVL-2014-010  July 17, 2014                                  32
OBJECTIVE, SCOPE, AND METHODOLOGY .................................

The primary objectives of this report were to document the increase in sales to the Enterprises
by smaller lenders and nonbank mortgage companies, discuss the reasons behind this trend,
and assess FHFA’s oversight of the Enterprises’ risk management controls.

To address these objectives, we interviewed officials in DER, DSPS, and DHMG as well as
members of the Enterprises’ single-family business and enterprise risk management groups.

To accomplish our quantitative analysis, we requested quarterly selling volume data from the
Enterprises. The data capture the total quarterly sale volume, as measured by the number of
mortgage loans and their total unpaid principal balance, to the Enterprises by each seller. It
also includes each seller’s industry classification code, as well as a breakdown of sale volume
by selling channels (e.g., cash window and swap transactions) for each individual seller.
The data used in this report cover the period from the first quarter of 2003 through the third
quarter of 2013. We shared the preliminary results of our analysis with FHFA and Enterprise
officials, who generally agreed with our analysis. However, we did not independently test the
reliability of the Enterprises’ data.

Finally, we also reviewed Enterprise policies and procedures for counterparty risk
management, Enterprise internal audit reports, DER examination plans, and planning and
findings memoranda associated with Enterprise examinations.

This study was conducted under the authority of the Inspector General Act and is in
accordance with the Quality Standards for Inspection and Evaluation (January 2012), which
was promulgated by the Council of the Inspectors General on Integrity and Efficiency. These
standards require OIG to plan and perform an evaluation that obtains evidence sufficient to
provide reasonable bases to support its findings and recommendations. We believe this report
meets these standards.

FHFA and the Enterprises provided technical comments on a draft of this report, which were
incorporated as appropriate.

The performance period for this evaluation was between October 2013 and May 2014.




                               OIG  EVL-2014-010  July 17, 2014                                 33
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  EVL-2014-010  July 17, 2014                         34