oversight

FHFA's Exercise of Its Conservatorship Powers to Review and Approve the Enterprises' Annual Operating Budgets Has Not Achieved FHFA's Stated Purpose

Published by the Federal Housing Finance Agency, Office of Inspector General on 2015-09-30.

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

             Federal Housing Finance Agency
                 Office of Inspector General




       FHFA’s Exercise of Its
 Conservatorship Powers to Review
   and Approve the Enterprises’
 Annual Operating Budgets Has Not
  Achieved FHFA’s Stated Purpose




Evaluation Report  EVL-2015-006  September 30, 2015
                             EXPLANATION OF REDACTIONS IN REPORT

     Redactions in this report were made at the request of the Federal Housing Finance Agency
EVL-2015-006
      (FHFA). According to FHFA, the redactions are intended to protect from disclosure material
      that2015
Date XX,   is confidential financial, proprietary business, and/or trade secret information. FHFA
      claims further that the redacted information would not ordinarily be publicly disclosed, and, if
      disclosed, could disadvantage Freddie Mac and Fannie Mae.
                Executive Summary
                Fannie Mae and Freddie Mac (collectively, the Enterprises) have been under
                the conservatorship of the Federal Housing Finance Agency (FHFA) since
                September 2008. In our annual Audit and Evaluation Plan, the Federal
                Housing Finance Agency Office of Inspector General (OIG) identified the
                operation of the conservatorships as a strategic risk and a focus of OIG’s work.
EVL-2015-006    This evaluation is the first of a number of projects in which OIG examines
                actions taken by FHFA as conservator for the Enterprises.
September 30,
    2015        In the beginning of the conservatorships, FHFA delegated to the Enterprises
                the authority to establish their annual operating budgets. Acting pursuant to
                this delegated authority, both Enterprises set their annual operating budgets for
                fiscal years 2009-2012. (The fiscal year for each Enterprise runs concurrently
                with the calendar year.) In November 2012, FHFA, acting as conservator,
                rescinded that delegation and determined to require review and approval of the
                Enterprises’ annual operating budgets. FHFA’s stated purpose for that action
                was to ensure that the budgets aligned with FHFA’s strategic direction and
                safety and soundness priorities.

                In 2012, the last year before FHFA required that the Enterprises obtain its
                approval for their budgets, the combined spending by both Enterprises totaled
                $3.9 billion. FHFA has approved the annual operating budgets for both
                Enterprises for fiscal years 2013, 2014, and 2015. For fiscal year 2015, FHFA
                approved spending in the combined Enterprise budgets that totaled $5.1
                billion—an increase of more than $1.2 billion, or approximately 31%, over
                2012 spending.

                This evaluation looks at whether the conservator’s budget approval process
                has been effective in ensuring that the budgets align with FHFA’s strategic
                initiatives and safety and soundness priorities.

                We found that FHFA’s budget review and approval process has not achieved
                FHFA’s stated purpose for re-asserting its approval authority because of late
                timing, cursory-level analysis, and inadequate resources. These shortcomings
                prevent FHFA from exercising effective control over Enterprise spending,
                both in amount and direction. As a consequence, FHFA’s budget review and
                approval process has imposed virtually no budget control on the Enterprises,
                and FHFA’s approval of the budgets creates the risk that it has endorsed
                Enterprise spending that has not been well understood by FHFA.

                After OIG finished its review for this evaluation in June 2015, FHFA
                determined in late July 2015 to enhance its budget review and approval
                process. OIG cannot assess the sufficiency of the newly approved changes
                to the budget review process until they are fully implemented. Based on
                the deficiencies identified by OIG in this evaluation, we make four
                recommendations to strengthen the budget review process. FHFA has agreed
                to three recommendations and generally agreed to one recommendation.

                This evaluation was led by Brian Stief, Investigative Counsel, who was
                assisted by Moira Roberts, Special Counsel. We appreciate the cooperation
EVL-2015-006    of FHFA staff, as well as the assistance of all those who contributed to the
                preparation of this report.
September 30,
    2015        This report has been distributed to Congress, the Office of Management and
                Budget, and others and will be posted on our website, www.fhfaoig.gov.




                Kyle D. Roberts
                Deputy Inspector General for Evaluations
TABLE OF CONTENTS ................................................................
EXECUTIVE SUMMARY .............................................................................................................3

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

BACKGROUND .............................................................................................................................7
      Governance Incentives..............................................................................................................9

FACTS ...........................................................................................................................................11
      Review and Approval Process for Enterprise Proposed Annual Budgets ..............................11
      Timeliness ...............................................................................................................................12
      Depth of DOC Analysis ..........................................................................................................13
      Level and Quality of DOC Resources ....................................................................................15
      DOC’s Acknowledgement of Deficiencies in its Budget Review Process .............................15
      FHFA’s Decision to Change its Budget Review Process .......................................................15

FINDINGS .....................................................................................................................................17
      1. Late budget submissions, cursory-level analysis, and inadequate resources
      undermine FHFA’s budget review process. ...........................................................................17
      2. FHFA’s budget review process has not achieved FHFA’s stated purpose of
      aligning Enterprise spending with FHFA’s strategic direction and safety and
      soundness priorities. ...............................................................................................................17

CONCLUSION ..............................................................................................................................19

RECOMMENDATIONS ...............................................................................................................20

OBJECTIVE, SCOPE, AND METHODOLOGY .........................................................................21

APPENDIX A ................................................................................................................................22
      FHFA’s Comments on OIG’s Findings and Recommendations ............................................22

APPENDIX B ................................................................................................................................25
      2015 Freddie Mac Budget Summary Table by DOC [REDACTED] ....................................25
      2015 Fannie Mae Budget Summary Table by DOC [REDACTED] ......................................26

ADDITIONAL INFORMATION AND COPIES .........................................................................27


                                          OIG  EVL-2015-006  September 30, 2015                                                               5
ABBREVIATIONS .......................................................................

Boards                         Enterprises’ Boards of Directors

DOC                            Division of Conservatorship

Enterprises                    Fannie Mae and Freddie Mac, collectively

Fannie Mae                     Federal National Mortgage Association

FHFA or Conservator            Federal Housing Finance Agency

Freddie Mac                    Federal Home Loan Mortgage Corporation

HERA                           Housing and Economic Recovery Act of 2008

LOIs                           Letters of Instruction

OIG                            Federal Housing Finance Agency Office of Inspector General

Treasury                       U.S. Department of the Treasury




                        OIG  EVL-2015-006  September 30, 2015                        6
BACKGROUND ..........................................................................

In September 2008, FHFA placed Fannie Mae and Freddie Mac into conservatorships
pursuant to its authority under the Housing and Economic Recovery Act of 2008 (HERA).1
HERA vested FHFA with sweeping powers as conservator.2 Since 2008, FHFA has
administered two conservatorships of unprecedented scope and undeterminable duration, and
simultaneously served as the regulator for two large, complex companies that dominate the
secondary mortgage market and the mortgage securitization sector of the U.S. housing finance
industry.

As conservator, FHFA is vested with express authority under HERA to operate the
Enterprises and has expansive authority over trillions of dollars in assets and billions of
dollars in revenue. FHFA also makes business and policy decisions that influence and impact
the entire mortgage finance industry. For reasons of efficiency, concordant goals with the
Enterprises, and operational savings, FHFA has determined to delegate authority for general
corporate governance and day-to-day matters to the Enterprises’ boards of directors (boards)
and executive management. As both Enterprises acknowledge, their directors serve on behalf
of the conservator and exercise their authority as directed by the conservator.3 The
conservator can revoke delegated authority at any time, and retain authority for certain
significant decisions. In practice, these are not bright lines; the conservator can intervene in
any issue or matter at the FHFA Director’s discretion.

In November 2008, FHFA issued “letters of instruction” (LOIs) to the Enterprises that defined
certain authorities it would retain as conservator, and delegated all others to the Enterprises.
Establishing annual operating budgets for the Enterprises was not a specific authority retained
by FHFA in these LOIs. Acting pursuant to this delegated authority, both Enterprises set their
annual operating budgets for fiscal years 2009-2012. (The fiscal year for each Enterprise runs



1
 Pub. L. No. 110-289, 122 Stat. 2654 (2008). HERA extensively amended the Federal Housing Enterprises
Financial Safety and Soundness Act of 1992, 12 U.S.C. §§ 4501-4642.
2
 For a full discussion of the conservator’s powers over the Enterprises, see OIG, FHFA-OIG’ s Current
Assessment of FHFA’s Conservatorships of Fannie Mae and Freddie Mac, at 26-28 (Mar. 28, 2012) (WPR-
2012-001) (online at www.fhfaoig.gov/Content/Files/WPR-2012-001.pdf); OIG, FHFA’s Conservatorships of
Fannie Mae and Freddie Mac: A Long and Complicated Journey (Mar. 25, 2015) (WPR-2015-002) (online at
www.fhfaoig.gov/Content/Files/WPR-2015-002_0.pdf) [hereinafter 2015 White Paper].
This report uses the term “conservator” to mean either FHFA or its Director, who exercises conservatorship
powers.
3
 Both Enterprises acknowledged this relationship in their 2014 Annual Reports. See, e.g., Fannie Mae,
Annual Report (Form 10-K), at 25 (Feb. 21, 2014); Freddie Mac, Annual Report (Form 10-K), at 20 (Feb. 27,
2014).



                                OIG  EVL-2015-006  September 30, 2015                                      7
concurrently with the calendar year.) In 2012, the combined spending by both Enterprises
totaled $3.9 billion.4

In November 2012, FHFA modified the LOIs to, among other things, revoke the delegation
of authority to the Enterprises to establish annual operating budgets without approval. As a
result, the Enterprises now are required to obtain FHFA’s approval of their annual budgets.5
Specifically, the 2012 LOIs issued by FHFA direct that Enterprise management must “consult
with and obtain the written approval of the conservator before taking action” to establish their
annual operating budgets.6 FHFA’s rationale for rescinding the Enterprises’ budget approval
authority and requiring FHFA review and approval was “to ensure that the [Enterprises’]
budgets [are] properly aligned with both FHFA’s strategic direction and its safety and
soundness priorities.”

FHFA, as conservator, has reviewed               FIGURE 1: ENTERPRISE ACTUAL (2012-2014) AND
and approved the Enterprises’ operating                   PROJECTED (2015) SPENDING
budgets for 2013, 2014, and 2015.
Combined 2015 Enterprise budgets total          $3,500
$5.1 billion—a $1.2 billion increase, or        $3,000
approximately 31%, over actual                  $2,500
                                                    Millions




spending in 2012. Combined year-over-           $2,000

year actual spending increased by $422          $1,500
                                                $1,000
million (11%) in 2013, $308 million
                                                 $500
(7%) in 2014, and is projected to
                                                    $0
increase by $480 million (10%) in 2015.                    2012        2013     2014        2015
Individually, Fannie Mae’s 2015 budget
                                                                Fannie Mae       Freddie Mac
represents an $875 million (37%)
increase from 2012 actual spending            Source: FHFA.
levels, while Freddie Mac’s 2015 budget
represents a $335 million (21%) increase over the same period (see Figure 1). To be sure, the
Enterprises reported record profits in 2013 of $132.6 billion in net income, of which $79
billion (60%) came from non-recurring events and in 2014 of $21.9 billion in net income, of
which $10 billion (45%) came from non-recurring events.7 Through the second quarter of

4
 Spending refers to the amount of actual expenses for a past fiscal year. Budget refers to the amount of
projected expenses.
5
 FHFA uses the term “administrative expenses” when it refers to the monies projected to be spent in the
Enterprises’ proposed operating budgets.
6
 FHFA, 2012 Letter of Instruction to Fannie Mae, at 2-4 (Nov. 15, 2012); FHFA, 2012 Letter of Instruction to
Freddie Mac, at 2-4 (Nov. 15, 2012).
7
 See OIG, The Continued Profitability of Fannie Mae and Freddie Mac Is Not Assured (Mar. 18, 2015)
(WPR-2015-001) (online at www.fhfaoig.gov/Content/Files/WPR-2015-001.pdf).



                                 OIG  EVL-2015-006  September 30, 2015                                       8
2015, the Enterprises have paid to the U.S. Department of the Treasury (Treasury)
approximately $239 billion in dividends for the U.S. taxpayers’ investment of $187.5 billion.
Their core earnings, from single-family, multifamily, and portfolio investment business
segments, increased from $27 billion in 2012 to $53 billion in 2013, but decreased to $12
billion in 2014.8

Governance Incentives

In most public companies, shareholders elect the board of directors. Typically, a public
company board of directors reviews and approves an annual operating budget proposed by
company management before the beginning of the company’s fiscal year. Because most
directors of public companies are subject to shareholder election every year (or every three
years for a staggered board), these directors are incentivized to improve shareholder returns
by controlling costs, increasing earnings, and building corporate net worth.9

Here, too, the boards of each Enterprise are required to approve management’s proposed
annual operating budgets before the proposed budgets are sent to FHFA for its review and
final approval. However, the corporate governance incentives that animate directors’ conduct
in most public companies are largely absent in board governance of the Enterprises. Because
the Enterprises are in conservatorship, their conservator, FHFA, retains ultimate authority to
appoint or remove Enterprise directors. Pursuant to the Enterprises’ agreements with the
Treasury, the Enterprises must sweep any excess of net worth (over a small capital reserve)
to Treasury.10 This mandatory sweep means that controlling costs and increasing net income
will not increase the net worth of the Enterprises. As a result, the Enterprises’ boards lack
the same incentives as boards of most public companies to build capital and enhance stock
performance by controlling costs and increasing earnings.11 This atypical governance
environment increases the importance of FHFA’s review of the Enterprises’ proposed annual
operating budgets.



8
    Id. at 8.
9
 See Robert A.G. Monks and Nell Minow, Corporate Governance (4th ed. 2008), at 223-235. See also, e.g.,
Michael McGrail, What Decisions Need Approval from Your Board of Directors, Cooley LLP (online at
www.cooleygo.com/decisions-need-approval-board-directors/).
10
   The agreements are the foundation for the $187.5 billion of taxpayer money invested in the Enterprises in
the wake of the financial crisis. As explained in OIG’s 2015 White Paper, the Enterprises have not drawn on
the Treasury commitment since 2012. Under the terms of their agreements with Treasury, Fannie Mae and
Freddie Mac may draw, if necessary, up to an additional $117.6 billion and $140.5 billion, respectively.
11
  Fannie Mae’s 2014 Annual Report expressly acknowledges this lack of incentive: “we are no longer
managed with a strategy to maximize shareholder returns.” Fannie Mae, Annual Report (Form 10-K), at 25
(Feb. 21, 2014).



                                 OIG  EVL-2015-006  September 30, 2015                                       9
Because HERA insulates FHFA’s actions as conservator from judicial review or
intervention,12 OIG’s oversight of FHFA’s ongoing work as conservator serves to review
whether FHFA is fulfilling its statutory responsibilities, with transparent reporting of its
results, in order to protect the interests of American taxpayers who have funded Treasury’s
$187.5 billion investment in the Enterprises. In this evaluation, OIG reviewed the
effectiveness of FHFA’s budget review and approval process. In a subsequent project, OIG
will trace where each Enterprise spent these increases. Forthcoming OIG evaluations and
audits will look at other aspects of FHFA’s management of the conservatorships.




12
   HERA states that “no court may take any action to restrain or affect the exercise of powers or functions of
[FHFA] as a conservator or receiver.” 12 U.S.C. § 4617(f). See, e.g., Babylon v. FHFA, 699 F.3d 221, 228
(2d Cir. 2012) (“A conclusion that the challenged acts were directed to an institution in conservatorship and
within the powers given to the conservator ends the [Court’s] inquiry.”). Two courts have held that FHFA’s
actions are subject to judicial review when FHFA acts beyond the scope of the conservatorship powers
authorized by HERA. See, e.g., Cf. Sonoma v. FHFA, 710 F.3d 987, 992 (9th Cir. 2013) (“[T]he anti-judicial
review provision is inapplicable when FHFA acts beyond the scope of its conservator power.”); Leon Cnty. v.
FHFA, 700 F.3d 1273, 1278 (11th Cir. 2012) (“The FHFA cannot evade judicial scrutiny by merely labeling its
actions with a conservator stamp.”).



                                 OIG  EVL-2015-006  September 30, 2015                                         10
FACTS .......................................................................................

Review and Approval Process for Enterprise Proposed Annual Budgets

The process established by FHFA for its review and approval of the Enterprises’ budgets
consists of a number of steps:

     1. FHFA staff attend internal budget meetings at each Enterprise during the last quarter
        of the fiscal year to gain information about proposed increases to each budget and
        proposed funding for major initiatives;

     2. The Enterprises submit proposed operating budgets for the next fiscal year that have
        been approved by their respective boards, supporting materials, and requests for
        conservator approval, to FHFA’s Division of Conservatorship (DOC);

     3. DOC reviews and analyzes the submissions, seeks clarification when needed, and
        summarizes its findings;

     4. DOC prepares memoranda for the Director setting forth its views on whether the
        proposed operating budgets should be approved;

     5. DOC reports its summary findings in a PowerPoint presentation to FHFA’s
        Conservatorship Committee, a forum in which senior FHFA officials and the FHFA
        Director discuss conservatorship-related issues and pending Enterprise requests;13

     6. DOC works to address any questions or resolve any concerns raised by the
        Conservatorship Committee;

     7. The Director reviews the DOC memoranda and supporting materials, and determines
        whether to endorse the DOC recommendations; and

     8. DOC communicates the Director’s decisions to the Enterprises.14



13
  The FHFA Director chairs the Committee, and its members consist of FHFA executives, such as the
Director’s Special Advisors; the FHFA General Counsel; and the Deputy Directors of DOC, the Division of
Housing Mission and Goals, and the Division of Enterprise Regulation. For more background on the
Conservatorship Committee and its role, see 2015 White Paper.
14
   After FHFA approval of the proposed operating budgets, DOC monitors the Enterprises’ spending against
the operating budgets during the year and, on a quarterly basis, updates the Conservatorship Committee on
actual spending against budget. Should an Enterprise project that its actual spending will exceed 7% of its
approved operating budget, it must seek conservator approval for this additional spending.



                                OIG  EVL-2015-006  September 30, 2015                                       11
As implemented within FHFA for the last three years, significant aspects of this budget
review process have undermined the robustness of FHFA’s budget review. We now discuss
each of these aspects.

Timeliness

For the last three years, all Enterprise proposed operating budgets but one were submitted to
FHFA after the start of the fiscal year. FHFA’s review of the proposed budgets consumed up
to three months. As a result, the Enterprises operated without conservator-approved budgets
in 2013, 2014, and 2015 for periods ranging from almost two months to almost six months.

        For fiscal year 2013, which began on January 1, 2013, Fannie Mae submitted its
         proposed budget to FHFA after January 1, while Freddie Mac submitted its proposed
         budget on December 21, 2012. FHFA approved Freddie Mac’s proposed budget in
         February 2013 and Fannie Mae’s proposed budget in June 2013.

        For fiscal year 2014, which began on January 1, 2014, both Enterprises submitted their
         proposed budgets to FHFA after January 1. A new FHFA Director began at FHFA
         in January 2014 and FHFA’s Conservatorship Scorecard, which tracks Enterprise
         compliance with FHFA’s Strategic Plan for the Conservatorships,15 was issued in May
         of that year. FHFA approved the proposed budgets for both Enterprises in June 2014.

        For fiscal year 2015, which began on January 1, 2015, both Enterprises submitted their
         proposed budgets to FHFA after January 1. FHFA approved Fannie Mae’s proposed
         budget in February 2015 and Freddie Mac’s proposed budget in April 2015.

The timing of budget submissions and approvals is shown in Figure 2. With the exception of
the 2013 Fannie Mae proposed budget,16 FHFA approved every submitted budget for the past
three years without any changes.




15
   FHFA’s 2014 Strategic Plan for the Conservatorships of Fannie Mae and Freddie Mac provides FHFA’s
vision for its implementation of the Agency’s obligations as conservator of the Enterprises. FHFA, The 2014
Strategic Plan for the Conservatorships of Fannie Mae and Freddie Mac (May 13, 2014) (online at
www.fhfa.gov/AboutUs/Reports/ReportDocuments/2014StrategicPlan05132014Final.pdf).
16
   For 2013, Fannie Mae submitted a proposed operating budget on January 25, 2013, with a 14% overall
increase. That day, FHFA directed Fannie Mae to revise its proposed budget to reduce its overall year-over-
year budget increase from 14% to below 10%.



                                 OIG  EVL-2015-006  September 30, 2015                                      12
            FIGURE 2: THE TIMING OF ENTERPRISE BOARD AND FHFA APPROVAL, 2013-2015




* Fannie Mae submitted its board-approved proposed 2013 operating budget to FHFA on January 25, 2013, and
  was directed by FHFA that same day to reduce its overall year-over-year budget increase from 14% to below
  10%. Fannie Mae revised its proposed 2013 budget and resubmitted the proposed budget on June 6, 2013.
** Freddie Mac submitted its proposed budget for 2013 to FHFA on December 21, 2012.

Depth of DOC Analysis

The Enterprises’ submissions to FHFA consist largely of the proposed operating budgets and
high-level spending data organized into broad categories of expenditures.17 One set of
categories presents spending totals for more than a dozen divisions (e.g., legal, human
resources, and multi-family divisions). Another set of categories presents total spending for
specific projects and particular purposes (e.g., spending related to safety and soundness
priorities and base operations). Where DOC identifies ambiguities or inconsistencies in the
budgeted numbers, DOC can seek supplementary materials from the affected Enterprise.
DOC’s analysis of core business items—which generally amount to at least 75% of the annual



17
  Submissions also generally include budget-related materials presented by Enterprise management to the
Enterprise board.



                                OIG  EVL-2015-006  September 30, 2015                                       13
budgets—is very limited. According to DOC, its review of those items was essentially
limited to tracking overall trends in spending and number of employees.

DOC conducts a somewhat more focused review of the Enterprises’ investment budgets—
proposed spending relating to the Enterprises’ corporate priorities. In 2014, proposed
spending for these priorities comprised 24% and 16% of Fannie Mae’s and Freddie Mac’s
proposed budgets, respectively, according to DOC. The additional attention DOC paid to this
spending was limited to whether the Enterprises’ priorities aligned with FHFA priorities and
did not include an effort to assess the appropriateness of the proposed spending.18

The DOC presentations to the Conservatorship Committee and its recommendation
memoranda to the Director generally summarized and reorganized the materials provided
by the Enterprises. For example, Appendix B contains tables in redacted form prepared by
DOC for the Conservatorship Committee for the proposed 2015 operating budgets that
identify the proposed monies budgeted for broad categories of expenditures for each
Enterprise. OIG’s review of DOC’s presentations to the Conservatorship Committee found
that these presentations did not contain any independent analysis by DOC of the proposed
budgets. In its recommendation memoranda from 2014 and 2015, DOC never concluded that
the proposed operating budgets were reasonable or aligned with FHFA’s strategic direction
and safety and soundness objectives. OIG found that DOC’s approval recommendations in
these memoranda stated that the Enterprise budgets “seem” reasonable and “appear” to align,
without any explanation of the basis for its statements. DOC has recommended FHFA
approval of each proposed operating budget it has reviewed.

In interviews with OIG, DOC officials offered several explanations for DOC’s lack of
in-depth analysis. A senior DOC official explained to OIG that FHFA exercised its
conservatorship authority to review and approve Enterprise budgets in order to educate
senior FHFA officials on Enterprise expenditures and provide a high-level review. Lacking
sufficient information and dedicated resources needed to critically analyze the budgets
proposed by the Enterprises, DOC relied largely upon the Enterprises’ analyses. DOC
asserted that the FHFA approval requirement imposed a discipline on the Enterprises in
developing proposed budgets.

OIG’s review found that DOC employees involved with the review of the proposed budgets
questioned the rigor of the Enterprises’ analyses on which FHFA largely relied for its review.


18
  In February 2015, FHFA asked the Enterprises to estimate the amounts in their budgets directed to
Conservatorship Scorecard items. FHFA uses its annual Conservatorship Scorecard to track Enterprise
compliance with FHFA’s Strategic Plan. Because FHFA requested this estimate after it approved Fannie
Mae’s proposed budget, Fannie Mae’s subsequent estimate played no role in FHFA’s budget review and
approval. In response, each Enterprise estimated that Scorecard-related expenditures totaled under 5% of its
budget, according to DOC.



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Level and Quality of DOC Resources

The level of resources dedicated to the budget review by FHFA is limited. For DOC
review of the Enterprises’ proposed operating budgets for 2015, DOC assigned principal
responsibility for review of the proposals and preparation of the Conservatorship Committee
presentation and DOC recommendation memoranda to one employee. Other DOC employees
reviewed that employee’s work, and DOC employees also attended Enterprise board meetings
during the year and assisted in reviewing materials submitted by the Enterprises. Internally,
DOC officials estimated that these combined reviews required the equivalent of one-half to
three-quarters of a full-time employee. DOC’s budget review process did not seek formal
input from FHFA employees in other FHFA divisions with programmatic expertise in the
Enterprises’ programs.

DOC’s Acknowledgement of Deficiencies in its Budget Review Process

In December 2014, the DOC employee tasked with primary responsibility for DOC’s budget
review highlighted two significant shortcomings with DOC’s budget review process in a
memorandum to DOC senior officials. The first identified shortcoming was DOC’s reliance
on Enterprise justifications for the amounts budgeted for specific projects other than those
related to FHFA priorities and the high-level review of proposed budgets by DOC. The
second identified shortcoming was the lack of DOC resources dedicated to the budget review,
both in terms of manpower and programmatic expertise.

The memorandum concluded that DOC’s budget review and approval process did not achieve
FHFA’s stated goal of requiring conservator approval to ensure that the Enterprises pursue
projects in alignment with FHFA’s strategic direction or safety and soundness priorities.19
It recommended that FHFA require conservator approval of Enterprise budgets only if an
Enterprise proposed a 10% or greater year-over-year increase, or if a proposed budget would
necessitate a draw from Treasury. After internal DOC review in which the recommendation
changed to require FHFA approval if an Enterprise proposed a 5% or greater year-over-year
trigger, DOC presented its revised memorandum to the Conservatorship Committee on
February 5, 2015.

FHFA’s Decision to Change its Budget Review Process

OIG advised FHFA in writing on February 2, 2015, that it commenced an evaluation of
FHFA’s budget review and approval process. At the Conservatorship Committee meeting
on February 5, 2015, DOC recommended that FHFA reduce the scope of its budget review

19
  The memorandum recognized that the budget approval process assisted FHFA in cataloguing and comparing
projects between the Enterprises, but noted that FHFA could obtain the same information without retaining
budget approval authority.



                               OIG  EVL-2015-006  September 30, 2015                                      15
and approval process. According to FHFA documents and officials, the recommendation was
rejected by the Committee because the conservatorship of the Enterprises warranted FHFA’s
continued review and approval of annual Enterprise budgets. OIG’s evaluation, including
review of requested materials and interviews of FHFA employees, ran from February 2, 2015,
through June 30, 2015. During our fact-finding process, OIG learned that DOC was
evaluating “lessons learned” from previous budget review cycles to propose improvements to
the budget process to the Conservatorship Committee. As of June 30, 2015, OIG understood
that DOC had not made a proposal to that Committee. In late July 2015, the Conservatorship
Committee agreed to enhance the existing budget review process. OIG cannot assess the
sufficiency of the newly approved changes to the budget review process until they are fully
implemented.




                          OIG  EVL-2015-006  September 30, 2015                             16
FINDINGS .................................................................................

1. Late budget submissions, cursory-level analysis, and inadequate resources
   undermine FHFA’s budget review process.

Save for one proposed Enterprise budget submitted prior to the beginning of the fiscal year,
over the past three years, the Enterprises submitted proposed annual operating budgets after
the start of their fiscal years, and FHFA approved those budgets anywhere from two to six
months after the start of the fiscal year. As a result, the Enterprises operated under proposed
budgets for months, and FHFA lacked the information to identify and correct any priority
misalignment until well into the year.

FHFA review of the proposed budgets has been largely based on spending totals organized
into broad categories. This high-level of summary information significantly limits FHFA’s
ability to analyze or understand the budgets with any granularity. As a consequence, FHFA’s
budget review process did little more than observe year-over-year budget trends and educate
FHFA staff. DOC has acknowledged that DOC employees assigned to review the
Enterprises’ proposed budgets, summarize their content, and prepare DOC’s recommendation
for two budgets now totaling more than $5 billion are insufficient to perform substantive and
critical analyses.

2. FHFA’s budget review process has not achieved FHFA’s stated purpose of aligning
   Enterprise spending with FHFA’s strategic direction and safety and soundness
   priorities.

Robust review by FHFA of the Enterprises’ annual budgets is especially important because
the Enterprises, both of which are public companies, are in conservatorship and must sweep
any excess of net worth (over a small capital reserve) to Treasury in dividends for Treasury’s
$187.5 billion investment in them. While the boards of each Enterprise are required to
approve management’s proposed annual operating budgets before the proposed budgets
are sent to FHFA for its review and final approval, the corporate governance incentives that
animate directors’ conduct in most public companies are largely absent in board governance
of the Enterprises, because the sweep of excess net worth means Enterprise boards cannot
build capital and enhance stock performance by controlling costs and increasing earnings.

This unique governance environment underscores the importance of FHFA’s review of the
Enterprises’ proposed annual operating budgets to protect the taxpayers’ investments and
ensure that the Enterprises are satisfying their statutory responsibilities. Because FHFA’s
budget review process has been hampered by late timing, cursory-level analysis, and



                            OIG  EVL-2015-006  September 30, 2015                               17
inadequate resources, FHFA’s stated purpose for requiring conservator approval of the
Enterprises’ budgets has not been achieved.




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CONCLUSION ............................................................................

FHFA’s stated rationale for requiring conservator approval of the Enterprises’ annual budgets
was to ensure that the budgets aligned with FHFA’s strategic direction and safety and
soundness priorities. FHFA’s budget approval process, as implemented, has not permitted
FHFA to achieve the stated purpose for its required approval. Cursory review of the
Enterprises’ proposed annual budgets by DOC, reliance on the Enterprises’ analyses to
support the proposed spending levels, and inadequate staff resources, combined with
submission of all but one of the proposed budgets after the start of the fiscal year, meant that
FHFA could not determine whether the proposed budgets aligned with FHFA’s strategic
direction and safety and soundness priorities. By approving the proposed budgets after a
review that was constrained in scope and resources, FHFA created the risk that it approved
spending that was unnecessary or wasteful, and/or inconsistent with its strategic direction or
safety and soundness priorities.

FHFA approved changes to its budget review process in July 2015. OIG cannot assess the
sufficiency of FHFA’s changes to the process until they are fully implemented. Based on
deficiencies identified by OIG in this evaluation, we make four recommendations to
strengthen the budget review process.




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

We recommend that FHFA:

   1. Direct each Enterprise to submit its proposed operating budget and supporting
      materials for the next fiscal year so that FHFA has sufficient time before the fiscal
      year begins to adequately analyze the proposals.

   2. Revise the existing budget review process and staff the review process with employees
      who have the qualifications and experience needed for critical financial assessments of
      the proposed Enterprise budgets to permit FHFA to determine whether each
      Enterprise’s budget aligns with FHFA’s strategic direction and its safety and
      soundness priorities.

   3. Set a date certain during the first quarter of 2016 by which FHFA will take final action
      on each proposed annual operating budget for 2016 and approve the budget by that
      date.

   4. Set a date certain, prior to January 31 of each subsequent fiscal year, by which FHFA
      will take final action on each proposed annual operating budget and approve the
      budget by that date.

OIG provided FHFA an opportunity to respond to a draft report of this evaluation. In its
comments, which are reprinted in their entirety in Appendix A, FHFA agreed with
recommendations 1, 2, and 3, and “generally agreed” to recommendation 4. FHFA also
provided technical comments on the draft report, which were incorporated as appropriate.




                           OIG  EVL-2015-006  September 30, 2015                               20
OBJECTIVE, SCOPE, AND METHODOLOGY .................................

The objective of this report was to assess FHFA’s process for review and approval of Fannie
Mae’s and Freddie Mac’s annual operating budgets, as required under the Revised Letters of
Instruction, against the stated purpose for the budget approval: ensuring budget alignment
with FHFA’s strategic direction and safety and soundness priorities.

To achieve this objective, we interviewed FHFA personnel involved with the creation and
execution of the budget review and approval process. Those interviewed included the Deputy
Director of DOC and the DOC staff who conducted the 2014 and 2015 annual budget
reviews. We also reviewed publicly available documents, internal DOC documents, and non-
public information provided by FHFA. Additionally, we reviewed relevant FHFA
communications within FHFA and with the Enterprises. We drew all financial information
from either FHFA internal documents or publicly available Enterprise financial statements.

Our work was conducted under the authority of the Inspector General Act and in accordance
with the Council of the Inspectors General on Integrity and Efficiency’s Quality Standards for
Inspection and Evaluation (January 2012). These standards require us to plan and perform an
evaluation based upon evidence sufficient to provide reasonable bases to support its findings
and recommendations. We believe that the findings and recommendations discussed in this
report meet these standards.

The fieldwork for this report was completed between February and June 2015. The
performance period for this evaluation was between February and August 2015.




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APPENDIX A .............................................................................

FHFA’s Comments on OIG’s Findings and Recommendations




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OIG  EVL-2015-006  September 30, 2015   23
OIG  EVL-2015-006  September 30, 2015   24
APPENDIX B..............................................................................

2015 Freddie Mac Budget Summary Table by DOC [REDACTED]




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2015 Fannie Mae Budget Summary Table by DOC [REDACTED]




                     OIG  EVL-2015-006  September 30, 2015   26
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-2015-006  September 30, 2015                       27