Senate Banking Committee

Published by the Federal Housing Finance Agency, Office of Inspector General on 2011-12-13.

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

        Testimony of Federal Housing Finance Agency Inspector General Steve A. Linick
             Hearing on “Oversight of the Federal Housing Finance Agency Part II”
                  Senate Committee on Banking, Housing, and Urban Affairs
                                      December 13, 2011

Thank you, Chairman Johnson and Ranking Member Shelby, for inviting me to testify before the
Senate Banking Committee. I appreciate the opportunity to summarize the work and findings of
the Federal Housing Finance Agency Office of Inspector General (FHFA-OIG) to date.

I am the Agency’s first Inspector General, and my office began operations following my
swearing in on October 12, 2010, in the midst of a housing crisis of historic proportions. Over
the past fourteen months, we have made great strides in hiring a professional staff and getting the
organization up and running. We have published 10 audits and evaluations and have
commenced numerous criminal and civil investigations. We also issued our second Semiannual
Report to Congress two weeks ago.1 Today, I will provide an assessment of emerging trends
based on the work we have conducted to date, describe our operations, and answer the
Committee’s questions.

FHFA-OIG oversees FHFA’s operations and programs. This oversight includes the Agency’s
regulation of the housing government-sponsored enterprises (GSEs) -- Fannie Mae, Freddie Mac,
and the 12 Federal Home Loan Banks; the GSEs’ approximately 12,000 employees; as well as
the conservatorships of Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac currently
own or guarantee home mortgages worth over $5 trillion and account for 70 percent of the
nation’s secondary mortgage market. To date, they have received $183 billion in taxpayer
money in order to ensure their continuing solvency.

FHFA-OIG’s mission is to promote the economy, efficiency, and effectiveness of FHFA’s
programs and operations. To carry out its mission, FHFA-OIG conducts, supervises, and
coordinates audits of FHFA’s programs and operations. FHFA-OIG also works to prevent and
detect fraud, waste, and abuse in those programs and operations through investigations involving
FHFA, Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Important features of
FHFA-OIG’s work are the promotion of transparency in FHFA programs and GSE oversight, as
well as public understanding of matters affecting FHFA, the GSEs, and housing policy.

    Available at http://www.fhfaoig.gov/Content/Files/second%20semiannual%20report.pdf.

                                        Emerging Trends

Our reports have revealed a number of emerging trends. These reports credit FHFA’s work in
several areas, both as regulator of the GSEs and conservator of Fannie Mae and Freddie Mac (the
Enterprises). For example, FHFA-OIG has found:
    FHFA has eliminated golden parachute compensation awards to terminated Fannie Mae
        and Freddie Mac executives;
    FHFA has taken steps to mitigate its shortage of qualified examiners;
    FHFA has increased underwriting standards and raised guarantee fees;
    FHFA has taken steps that may improve Enterprise repurchase claims recoveries, thereby
        reducing Enterprise losses; and
    FHFA has positively responded to FHFA-OIG’s recommendations to improve FHFA’s
        effectiveness and efficiency and to reduce its vulnerability to fraud, waste, and abuse.

On the other hand, FHFA-OIG reports also have identified deficiencies in FHFA operations, and
these deficiencies appear to reflect two significant and related trends. First, FHFA often relied
on determinations of the Enterprises without independently testing and validating them, thereby
giving undue deference to Enterprise decision-making. Second, FHFA was not proactive in
oversight and enforcement, and accordingly, resource allocations may have affected its ability to
oversee the GSEs and enforce its directives. Both trends have emerged in a number of our

I. FHFA Has Not Independently Tested and Validated Enterprise Decision-Making

In four reports, FHFA-OIG identified significant instances in which FHFA has displayed undue
deference to Enterprise decision-making. Without adequately testing or validating data, FHFA
has deferred to the Enterprises regarding: (1) Freddie Mac’s assessment of mortgage repurchase
claim issues involving Bank of America; (2) the Enterprises’ participation in the Making Home
Affordable programs (MHA); (3) the Enterprises’ decisions regarding executive compensation;
and (4) numerous Enterprise transactions.

The Agency’s actions in each case reflect its approach as conservator to delegate most business
decisions to the Enterprises. In each case, it relied upon review and corporate governance
processes already in place at the Enterprises. However, FHFA-OIG concluded that some matters
are sufficiently important to warrant greater involvement and scrutiny by the Agency.

       a. FHFA Deferred to Freddie Mac’s Analysis of Repurchase Claim Exposure

At the end of 2010, FHFA approved a $1.35 billion settlement of mortgage repurchase claims
that Freddie Mac asserted against Bank of America. In approving the settlement, FHFA relied
on Freddie Mac’s analysis of the settlement without testing the assumptions underlying the
Enterprise’s existing loan review process. An FHFA-OIG report found that FHFA did not act
timely or test concerns raised by an FHFA senior examiner months prior to the settlement about
limitations in Freddie Mac’s existing loan review process for mortgage repurchase claims. The
senior examiner was concerned that the loan review process Freddie Mac used for repurchase
claims failed to account adequately for changes in foreclosure patterns among loans originated
during the housing boom. According to the senior examiner, this could potentially cost the
Enterprise a considerable amount of money.2 Freddie Mac’s internal auditors independently
identified concerns about the process and in June 2011, recommended that the issue be studied
further. Following initiation of FHFA-OIG’s report, FHFA suspended future Enterprise
mortgage repurchase settlements premised on the Freddie Mac loan review process and set in
motion activities to test the assumptions underlying the loan review process.

           b. FHFA Provided Limited Oversight of the Enterprises’ Administration of the Home
              Affordable Modification Program

In early 2009, the Department of the Treasury initiated the Making Home Affordable (MHA)
programs. A key initiative of MHA is the Home Affordable Modification Program (HAMP),
which involves servicers agreeing to modify mortgages for borrowers facing default or
foreclosure. In early 2009, the Enterprises began participating in HAMP. They started
modifying mortgages in their portfolios and entered into five-year agreements with Treasury to
manage the program and oversee participants’ compliance with program requirements. An
FHFA-OIG report found that FHFA largely removed itself from overseeing the negotiations of
the five-year agreements. FHFA believed its appropriate role was to ensure the Enterprises were
legally authorized to administer HAMP, not to participate actively in negotiations between the
Enterprises and Treasury. In other words, FHFA did not engage in any formal substantive
review to evaluate the agreements’ feasibility, risks, or the suitability of the Enterprises to serve
as Treasury’s financial agents. This lack of engagement may have contributed to the
agreements’ omission of significant details concerning payments to the Enterprises, the scope of
their responsibilities, and processes to resolve differences. As a consequence of the omissions,
significant problems developed in these areas almost from the beginning, requiring FHFA and
the Enterprises to devote substantial time and resources to resolve ambiguities.3

           c. FHFA Did Not Fully Analyze Factors Related to Executive Compensation at Fannie
              Mae and Freddie Mac

For 2009 and 2010, the Enterprises awarded their top six officers a cumulative total of over $35
million in compensation. FHFA reviewed and approved these compensation awards based on
    Available at http://www.fhfaoig.gov/Content/Files/EVL-2011-006.pdf.
    Available at http://www.fhfaoig.gov/Content/Files/EVL-2011-003.pdf.

the Enterprises’ determinations and recommendations. However, an FHFA-OIG report found
that FHFA did not independently test or validate the means by which the Enterprises calculated
their recommended compensation levels and did not consider factors that might have resulted in
reduced executive compensation costs. These factors included the lower compensation levels
paid to senior officials at federal agencies supporting the housing market and the extent to which
federal support for the Enterprises may facilitate the ability of Enterprise officers to meet
individual and corporate performance targets.4

       d. FHFA Does Not Perform Sufficient Transaction Testing of Enterprise Activities

Transaction testing is the method employed by financial institution examiners to make
independent judgments about the financial and operational conditions of an institution, as well as
its compliance with applicable laws and regulations. An example of transaction testing would be
reviewing a regulated entity’s loan files to test the veracity of statements concerning loan
underwriting and performance. During an evaluation of FHFA’s capacity to examine the GSEs,
a senior FHFA manager acknowledged to FHFA-OIG that examiners too often accept assertions
made by Enterprise managers rather than independently validate such assertions through
appropriate transaction testing.5

II.   FHFA’s Resource Allocations May Have Affected Its Ability to Oversee the GSEs
and Enforce Its Directives

In four reports, FHFA-OIG identified instances in which FHFA was not proactive in oversight
and enforcement, and accordingly, resource allocations may have affected its ability to oversee
the GSEs and enforce its directives. For example, FHFA did not assign sufficient priority and
resources to handle consumer complaints. Additionally, FHFA-OIG found that FHFA (along
with its predecessor agency, the Office of Federal Housing Enterprise Oversight (OFHEO)) has
permitted Fannie Mae to delay for five years the directives to implement an effective operational
risk management program. Further, FHFA may not have allocated resources to or prioritized
addressing new and emerging risks that may impact the GSEs. Finally, FHFA reported that it
may have too few examiners to meet its oversight responsibilities. Some of FHFA’s lack of
oversight may have resulted from a lack of examination capacity, while other shortfalls may
stem from a misallocation of resources.

  Available at
  Available at http://www.fhfaoig.gov/Content/Files/EVL-2011-005.pdf.

           a. FHFA Did Not Allocate Sufficient Resources to Handle Consumer Complaints

Due in part to deteriorating financial conditions in the housing market, FHFA and OFHEO
experienced a substantial increase in consumer complaints about the Enterprises. A number of
these complaints contained important information about alleged foreclosure processing abuses
and fraud. However, an FHFA-OIG report found that FHFA did not adequately process
consumer complaints. For example, the Agency did not: develop and maintain a consolidated
system for receiving or processing complaints; consistently follow up on complaints referred to
the Enterprises; prioritize complaints or assess the timeliness of responses to complaints; refer
complaints to law enforcement for evaluation or possible investigation; or perform substantive
analyses to identify overall trends in complaints. These deficiencies occurred because FHFA did
not establish adequate internal controls and did not assign sufficient priority and resources to
complaint processing. FHFA-OIG found that FHFA assigned only two employees – on a part-
time basis – to handle consumer complaints.6 FHFA’s lack of oversight and prioritization in this
area stemmed from its view that, among other things, addressing consumer complaints was not
its role.

           b. FHFA Has Not Enforced Directives Regarding Fannie Mae’s Operational Risk

In 2006, OFHEO issued a Consent Order requiring Fannie Mae to establish an operational risk
management program. FHFA views operational risk management as an important financial
safety and soundness challenge facing the Enterprises. The Agency defines operational risk as
the risk of loss resulting from failures in people, processes, systems, or from external events
(such as foreclosure abuses). Between 2006 and 2011, FHFA and OFHEO repeatedly found that
Fannie Mae had failed to establish an acceptable and effective program despite outstanding
requirements to do so. As Fannie Mae’s conservator and regulator, FHFA’s authority over the
Enterprise is broad and includes the ability to discipline or remove Enterprise personnel to ensure
compliance with Agency mandates. However, an FHFA-OIG report found that FHFA has not
exercised this or other authorities to compel Fannie Mae’s compliance with the operational risk
requirement.7 Fannie Mae’s lack of an acceptable and effective operational risk management
program may have resulted in missed opportunities to strengthen oversight of law firms with
which it contracts to process foreclosures.

    Available at http://www.fhfaoig.gov/Content/Files/AUD-2011-001.pdf.
    Available at http://www.fhfaoig.gov/Content/Files/EVL-2011-004.pdf.

           c. FHFA Did Not Identify and Address New and Emerging Risks Potentially Impacting
              the GSEs

Only after news of foreclosure abuses surfaced in mid-2010 did FHFA begin to schedule
comprehensive examination coverage of foreclosure issues, including allegations of abuse by its
default-related legal services vendors. FHFA had not previously considered risks associated
with foreclosure processing to be significant. However, an FHFA-OIG report found that there
were multiple indications of foreclosure issues prior to mid-2010 that could have led FHFA to
foresee the heightened risk in foreclosure processing abuses. These indications included
significant increases in the volume of foreclosures (which accompanied the collapse of the
housing market), rising consumer complaints alleging improper foreclosures, contemporaneous
media reports about foreclosure abuses by the Enterprises’ law firms, and public court filings
highlighting such abuses.8

           d. FHFA May Not Have Enough Examiners to Meet Its Regulatory and Conservatorship
              Oversight Responsibilities

FHFA has critical regulatory responsibilities with respect to the GSEs and conservator
responsibilities regarding the Enterprises. To satisfy these responsibilities, Congress provided
FHFA significant budget and hiring authority. Nonetheless, an FHFA-OIG report noted that
FHFA had found shortfalls in the Agency’s examination coverage. Internal Agency reviews also
corroborated that FHFA believes it has too few examiners to ensure the efficiency and
effectiveness of its examination program. Additionally, only 34% of the Agency’s line
examiners are accredited federal financial examiners. FHFA has taken steps to mitigate its
shortage of qualified examiners, but it needs to move quickly and aggressively in this area. Last
winter, for example, the Acting Director announced and implemented a substantial restructuring
of FHFA’s supervision units and reassigned numerous staff. These steps, which also include
plans to add examination staff and implement an examiner accreditation program, are designed
to enhance FHFA’s supervision program. Further, although FHFA’s near-term plans include
hiring up to 44 additional staff in the supervision divisions, FHFA believes there is substantial
uncertainty as to whether this number of additional examiners will enable FHFA to overcome its
examination capacity shortfalls and ensure the success of the Agency’s 2011 reorganization of its
examination structure.9 Insufficient examination capacity contributed to FHFA’s lack of
oversight by leaving key areas unchecked. For example, until recently there had been no
targeted examinations involving the real estate owned (REO) area.

    Available at http://www.fhfaoig.gov/Content/Files/AUD-2011-004.pdf.
    Available at http://www.fhfaoig.gov/Content/Files/EVL-2011-005.pdf.

                                  OIG Audits and Evaluations

In addition to monitoring and reporting on FHFA’s progress in implementing report
recommendations, FHFA-OIG will continue to release new audits and evaluations covering key
areas. FHFA-OIG maintains a detailed Audit, Evaluation, and Survey Plan that focuses
strategically on the areas of FHFA’s operations posing the greatest risks and providing the
greatest potential benefits to FHFA, Congress, and the public. Originally developed with input
from an independent, third-party risk assessment, the Audit, Evaluation, and Survey Plan reflects
continuous feedback from FHFA-OIG’s reviews of current events and comments from FHFA
officials, members of Congress, and others. Broadly, FHFA-OIG’s audit and evaluation
strategies include reviews of the following FHFA activities:

      Regulatory efforts and its management of the Enterprise conservatorships. This is a
       particularly high-risk area because Treasury has to date invested $183 billion of taxpayer
       funds in the Enterprises. As conservator, FHFA must regulate and oversee the
       Enterprises in an efficient, effective, and transparent manner so as to minimize taxpayer
       costs, conserve Enterprise resources, and meet all statutory mandates.
      Oversight of the Federal Home Loan Banks and their associated risks, including
       investment portfolio management and concentrations, credit underwriting, and
      Internal operations, such as privacy and allegations of fraud, waste, or abuse.

The Audit, Evaluation, and Survey Plan identifies a number of other ongoing and planned
reviews of specific FHFA programs.

Given the Committee’s interest, I want to highlight two projects currently underway. First, we
are assessing whether FHFA has an effective supervisory control structure and sufficient
examination coverage to adequately and timely identify and mitigate mortgage servicing risks.
We are also assessing FHFA’s oversight of Enterprise controls over real estate owned (REO)
operations, including management and sales activities and contractor performance. Given the
breadth and importance of issues relating to servicing and REO, no doubt we will continue to
examine them from various angles for some time to come. We look forward to working with
you on these matters and reporting our findings and recommendations to the Committee.


As a further part of our mission to combat fraud, waste, and abuse, FHFA-OIG operates an
active Office of Investigations that has made significant contributions to a range of mortgage-
related investigations. While many remain confidential, FHFA-OIG and its law enforcement
partners, which include federal agencies, U.S. Attorneys’ Offices, and state and local agencies
nationwide, have released details about several high-profile mortgage fraud investigations
involving Colonial Bank and Taylor, Bean & Whitaker Mortgage Corporation, Marshall Home
and Margaret Broderick, and Home Owners Protection Economics, Inc.

FHFA-OIG’s Office of Investigations currently has numerous open criminal and civil
investigations involving a wide variety of allegations of wrongdoing. The Office of
Investigations focuses on FHFA and the GSEs, both internally and externally, concentrating on
those individuals and organizations that have victimized either FHFA or the GSEs or borrowers
with GSE loans. While I cannot comment on specific open cases, I can describe the trends we
are seeing in fraud. The types of cases that we are actively investigating generally fall into the
following six categories:

              Fraud involving mortgage-backed securities
              Mortgage origination related frauds
              Short sale and other mortgage modification frauds
              Fraud involving REO transactions
              Fraud involving mortgage servicing
              FHFA or GSE employee misconduct

Fraud Involving Mortgage-Backed Securities is a key area of focus. During the pre-crisis
housing boom, the GSEs purchased and guaranteed hundreds of billions of dollars of residential
mortgage-backed securities that have since declined precipitously in value due to the sharp
deterioration in the value of those assets. The GSEs may have been victims of fraud in instances
where the quality and value of the underlying assets they purchased or guaranteed was
misrepresented to them.

Mortgage Origination related frauds include cases where the GSEs have been defrauded as the
loan was being underwritten and sold to a GSE. These are the most commonly known frauds
and could include schemes such as loan officers funding mortgages for otherwise ineligible
borrowers. For example, one recent allegation reviewed by my office involved a borrower
whose loan was funded despite the fact that the borrower was deceased. We have also seen
schemes involving appraisers inflating the value of the property and straw buyers.

Short Sale frauds can include allegations of a non-arm’s length transaction in which financial
institutions are deceived into allowing a short sale through a straw buyer for a significantly lower
price. Once the price decline is captured, the property is sold at the lower price to a relative or
friend of the seller, with the owners ultimately staying in the property at a considerable loss to
the GSE. In one of our cases, the average transaction loss to the GSE was approximately

Mortgage Modification frauds are a particularly insidious fraud. This type of fraud targets
financially distressed homeowners who are underwater or have fallen behind on their mortgage
payments. Some frauds involve advance fee schemes that require the homeowner to pay a fee
for participating in supposedly “official” programs that are in fact completely fictitious or
improperly imply participation in a U.S. government housing relief program. Besides scamming
vulnerable homeowners out of money they can ill afford to lose, these schemes are particularly
harmful because by the time borrowers recognize the scam, they may have been foreclosed upon
and have little recourse. Other scams are designed to force a distressed homeowner into default
sooner than would otherwise be the case.

REO Related frauds may involve individuals connected to the foreclosure and subsequent resale
of a property. This situation provides multiple opportunities for fraud. For example, the GSEs
contract with so-called asset managers to maintain and prepare the property for sale. These asset
managers may sub-contract work to gardening companies to cut the grass, but the grass isn’t cut;
or they may contract with electricians for “required” maintenance that was neither required nor
done, but still subsequently billed to a GSE. REO fraud can also involve realtors who collude
with investors or other realtors and appraisers to drive down the price of properties they are
selling on behalf of the GSEs. Over the past year, the Department of Justice’s Anti-Trust
Division has announced a number of convictions of real estate investors involved in such bid-
rigging schemes designed to deflate property auction prices.

Fraud Involving Mortgage Servicing can include allegations that the mortgage servicer is not
acting in the best interest of the GSE or the investor. For example, a mortgage servicer may
make decisions regarding modifications or loan foreclosures with its own personal benefit in
mind and contrary to GSE guidelines.

FHFA or GSE Employee Misconduct is another type of fraud. These are cases in which specific
allegations are made involving administrative or criminal misconduct by FHFA or GSE
employees or contractors.

Finally, I want to mention that the Office of Investigations operates the FHFA-OIG Hotline,
which allows concerned parties to report information directly and in confidence regarding
possible fraud, waste, or abuse related to FHFA or the GSEs. In the past year it has handled
many allegations of wrongdoing or fraud. FHFA-OIG honors all applicable whistleblower

protections. Should you or your constituents wish to report any allegations of fraud, waste, or
abuse, the Hotline can be reached at 1-800-793-7724, by fax at 202-408-2972, or through our
website at www.fhfaoig.gov.

My staff and I look forward to continuing to work with the Banking Committee to provide
independent, relevant, and objective assessments of FHFA’s operations and programs. The
continuing fragility of our nation’s housing market remains a significant source of ongoing
concern. Further, Fannie Mae, Freddie Mac, and the Federal Home Loan Banks continue to be
key market participants, and FHFA continues to face significant challenges. We are hopeful that
our work will be of assistance in meeting those challenges.