oversight

Overview of the Risks and Challenges the Enterprises Face in Managing Their Inventories of Foreclosed Properties

Published by the Federal Housing Finance Agency, Office of Inspector General on 2012-06-14.

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

          FEDERAL HOUSING FINANCE AGENCY
            OFFICE OF INSPECTOR GENERAL



        Overview of the Risks and Challenges the
     Enterprises Face in Managing Their Inventories
                 of Foreclosed Properties




WHITE PAPER: WPR-2012-003                DATED: June 14, 2012
                                      FEDERAL HOUSING FINANCE AGENCY
                                        OFFICE OF INSPECTOR GENERAL

                                                 AT A GLANCE
                                                      titlethe Enterprises Face in Managing
                     Overview of the Risks and Challenges
                                   Their Inventories of Foreclosed Properties

Background                                                      Summary
The Housing and Economic Recovery Act of 2008 (HERA)            The Enterprises have been dealing with surging foreclosure rates,
established the Federal Housing Finance Agency (FHFA or         rising REO inventories, and associated costs since the onset of the
Agency) as the supervisor and regulator of the Federal          U.S. housing and financial crises in 2007 and 2008. By the end of
National Mortgage Association (Fannie Mae) and the Federal      2011, their REO inventories had more than tripled to nearly
Home Loan Mortgage Corporation (Freddie Mac)                    180,000 units and their related expenses totaled $8.5 billion.
(collectively, the Enterprises). In September 2008, the         Further, given the financial distress in which many American
Enterprises entered into conservatorships overseen by FHFA      homeowners continue to find themselves, the Enterprises are likely
out of concern that their deteriorating conditions threatened   to face elevated REO inventories and costs for years to come.
the stability of financial markets. Simultaneously, the U.S.
                                                                As the Enterprises’ conservator and regulator, FHFA has a critical
Treasury Department (Treasury) began providing financial
                                                                responsibility to oversee their REO management efforts. A failure
assistance – more than $187 billion to date – to support the
                                                                in Enterprise efforts to secure and maintain foreclosed properties
Enterprises during the conservatorships.
                                                                could drive up Enterprise losses and cause damage in affected
The Enterprises purchase mortgages from lenders and then        communities, e.g., foreclosed properties can lower the value of
keep them as investments or package them into securities that   surrounding properties and increase blight and crime.
are sold to investors. When borrowers default on such
                                                                In recent examinations, FHFA concluded that the Enterprises
mortgages they may become subject to foreclosure
                                                                should significantly improve their REO management efforts. The
proceedings. In many cases, the Enterprises take possession
                                                                Agency identified deficiencies in the Enterprises’ management of
of foreclosed properties and resell them in an effort to
                                                                the large contractor networks they employ for many REO tasks,
recover some of their losses. The process of securing,
                                                                including inadequate property inspections and insufficient controls
maintaining, repairing, and selling foreclosed properties is
                                                                to detect fraudulent reimbursements. FHFA plans to follow up on
often referred to as Real Estate Owned (REO) management.
                                                                these findings in 2012.
Scope                                                           Additionally, FHFA is working with Fannie Mae to implement a
In this white paper, the FHFA Office of Inspector General       pilot program under which investors may buy foreclosed properties
(FHFA-OIG) discusses: (1) the basics of the foreclosure and     in bulk if they agree to offer them for rent for specified periods.
REO management processes; (2) the critical role that            The intent of the program is to determine whether such an
Enterprise contractor oversight plays in REO management;        arrangement is a viable means to reduce REO inventories and meet
(3) key Enterprise REO management challenges; (4) FHFA’s        rental demands.
oversight of the Enterprises’ REO management; and (5)
FHFA’s and Fannie Mae’s development of an REO pilot
                                                                FHFA-OIG REO Strategy
program under which investors can purchase in bulk              FHFA-OIG has several ongoing audits of key aspects of FHFA’s
foreclosed properties with rental commitments. Given the        oversight of the Enterprises’ REO management, such as property
risks associated with REO management, FHFA-OIG places a         maintenance and contractor reimbursement controls. FHFA-OIG
high priority on it. Accordingly, this white paper also         also plans to evaluate the programmatic controls that are intended
identifies FHFA-OIG’s strategy for assessing FHFA’s             to prevent fraud in the REO pilot program should it be expanded.
oversight of the Enterprises’ REO management efforts.

WHITE PAPER: WPR-2012-003                                                                            Dated: June 14, 2012
TABLE OF CONTENTS
TABLE OF CONTENTS .................................................................................................................3

ABBREVIATIONS .........................................................................................................................4

PREFACE ........................................................................................................................................5

BACKGROUND .............................................................................................................................7
      About FHFA and the Enterprises .............................................................................................7
      Basics of the Foreclosure and REO Management Processes....................................................7
      Effective Contractor Oversight Is a Critical Component of the Enterprises’ REO
      Management Processes .............................................................................................................9
      The Enterprises Face Significant Challenges and Risks in Managing Their REO
      Inventories ..............................................................................................................................14
      FHFA Oversight of Enterprise REO Management .................................................................23
      FHFA’s and Fannie Mae’s Pilot Program Is Testing the Concept of Selling in Bulk
      Foreclosed Properties with Rental Commitments ..................................................................24

FHFA-OIG’S STRATEGY FOR ASSESSING FHFA’S OVERSIGHT OF THE
ENTERPRISES’ REO MANAGEMENT .....................................................................................29

SCOPE AND METHODOLOGY .................................................................................................32

MAJOR CONTRIBUTORS TO THIS REPORT ..........................................................................33

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




             Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                                       3
ABBREVIATIONS
Fannie Mae......................................................................... Federal National Mortgage Association
FHFA or Agency.......................................................................... Federal Housing Finance Agency
FHFA-OIG ..................................... Federal Housing Finance Agency, Office of Inspector General
Freddie Mac .................................................................. Federal Home Loan Mortgage Corporation
HERA.......................................................................Housing and Economic Recovery Act of 2008
HPI ....................................................................................................................... House Price Index
MBS ................................................................................................ Mortgage-Backed Security(ies)
MRA ...................................................................................................... Matter Requiring Attention
REO..................................................................................................................... Real Estate Owned
Treasury .................................................................................................. U.S. Treasury Department




             Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                                     4
                                      Federal Housing Finance Agency
                                        Office of Inspector General
                                              Washington, DC



                                                PREFACE
Since the onset of the U.S. financial and housing crises in 2007 and 2008, the Enterprises have
faced significant challenges in managing their REO inventories, which, by the end of 2011,
tripled to nearly 180,000 units and resulted in total costs of approximately $8.5 billion.1
Moreover, the Enterprises are likely to face additional REO management challenges due to the
fact that more than 1.1 million of the mortgages they presently own or guarantee are seriously
delinquent. In these circumstances, FHFA has a critical responsibility to ensure that the
Enterprises manage their REO inventories so as to minimize costs and mitigate the negative
effects that foreclosed properties can have on the communities in which they are located.

In this white paper, FHFA-OIG provides an overview of Enterprise REO management and
FHFA’s oversight and conservatorship activities. Specifically, it discusses: (1) the basics of the
foreclosure and REO management processes; (2) the critical role that Enterprise contractor
oversight plays in REO management; (3) key Enterprise REO management challenges;
(4) FHFA’s oversight of the Enterprises’ REO management; and (5) Fannie Mae’s and FHFA’s
development and implementation of an REO pilot program under which investors are granted the
opportunity to purchase foreclosed properties in bulk as long as they agree to offer the properties
for rent over specified periods.

In addition, this paper contains a discussion of FHFA-OIG’s strategy for future audits and
evaluations concerning FHFA’s oversight of the Enterprises’ management of their REO
properties. The strategy includes two ongoing audits of FHFA’s oversight of the Enterprises’
controls over contractors that are directly responsible for many day-to-day REO management
tasks, such as securing and maintaining properties, as well as an audit of FHFA’s REO risk
assessment process. Further, the strategy includes an evaluation of the controls and monitoring
systems that FHFA and Fannie Mae may employ in the REO pilot program currently under
development should the pilot be expanded.
1
  When the Enterprises take titles to properties through the foreclosure process, they realize credit losses on the loans
plus certain other expenses. Subsequently, the Enterprises incur specific REO-related costs during the period
properties are in their REO inventories. These latter REO costs, which totaled $8.5 billion from 2007 through 2011,
represent maintenance and other property expenses, the fair market value gains or losses of a foreclosed property
during the time it is in the REO inventory, gains or losses at the time the property is resold to homeowners or
investors, and offsets from mortgage insurance or other sources. Although these REO expenses are accounted for
separately, they are a component of the Enterprises’ overall credit losses.


           Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                           5
This FHFA-OIG white paper has been distributed to Congress, the Office of Management and
Budget, and others, and will be posted on FHFA-OIG’s website, www.fhfaoig.gov.




Richard Parker
Director, Office of Policy, Oversight, and Review




         Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                    6
BACKGROUND
About FHFA and the Enterprises

On July 30, 2008, HERA established FHFA as the regulator of Fannie Mae, Freddie Mac, and
the Federal Home Loan Bank System. Among its responsibilities, FHFA oversees Fannie Mae’s
and Freddie Mac’s safety and soundness, supervises their efforts to support housing finance and
affordable housing goals, and facilitates a stable and liquid mortgage market. HERA also
expanded the authority of Treasury to provide financial support to the Enterprises.

On September 6, 2008, FHFA became Fannie Mae’s and Freddie Mac’s conservator. As such,
the Agency is charged with preserving and conserving the Enterprises’ assets, ensuring that they
focus on their housing mission, and facilitating their emergence from conservatorship.
Additionally, pursuant to its authority under HERA, as of March 31, 2012, Treasury had
provided $187.5 billion to the Enterprises, thereby enabling them to remain solvent and continue
their operations.2

The Enterprises support the secondary mortgage market by purchasing residential mortgages
from loan originators such as banks and credit unions. The loan originators may then use the
proceeds of these transactions to originate more mortgages. The Enterprises may hold mortgages
in their investment portfolios or package them into mortgage-backed securities (MBS) that they
sell to investors. In exchange for a fee, the Enterprises guarantee that MBS investors will receive
timely payment of principal and interest on their MBS investments.

Basics of the Foreclosure and REO Management Processes

The Enterprises retain the credit risk associated both with the mortgages they hold in their
investment portfolios as well as those for which they provide guarantees to MBS investors. That
is, the Enterprises retain the risks that borrowers will default on their mortgages and may
ultimately face foreclosure proceedings. At that point, the Enterprises generally seek to take
possession of foreclosed properties and sell them to offset their losses. The process of
safeguarding, maintaining and repairing, and marketing and selling foreclosed properties is often
referred to as “REO management.”

Typically, when a borrower fails to make mortgage payments for 90 days, the borrower is
considered to be seriously delinquent. In such cases, the Enterprises, working through their


2
 This includes $41 billion in dividends that the Enterprises are required to pay Treasury under the terms of their
Senior Preferred Stock Purchase Agreements with Treasury.


           Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                          7
                                                                                                    3
mortgage servicers, will generally initiate workout strategies to assist the borrower. For
example, Fannie Mae and Freddie Mac may institute loan modifications intended to lower a
borrower’s monthly payments, such as those offered through Treasury’s Home Affordable
                       4
Modification Program. But in cases in which these efforts prove unsuccessful, the Enterprises
may initiate foreclosure proceedings.

Foreclosure proceedings are the means by which the owner of a defaulted mortgage loan, such as
one of the Enterprises, may recover amounts due and owing by taking ownership of, or
repossessing, the property that secures a loan. In general, foreclosure proceedings begin when
the mortgage servicer files a lawsuit against the homeowner or notifies the homeowner of the
initiation of foreclosure proceedings. If the homeowner cannot “cure” the default, i.e., pay what
is due and owing, then the process may culminate in a public auction known as a foreclosure
sale.5 At the foreclosure sale the owner of the mortgage, e.g., an Enterprise via its servicer, may
buy the property and take possession of it. Alternatively, a third party, such as an investor, may
buy the property at the foreclosure sale.6

When an Enterprise takes possession of a foreclosed property, the effectiveness of its REO
management program may affect the value of the property and influence the Enterprise’s
ultimate associated credit loss. To keep its credit loss as low as possible, the Enterprise must
maximize its resale proceeds, among other means, by minimizing the expenses associated with
managing and reselling the property. The expenses associated with an REO property include
taxes, maintenance, repair, and upkeep – all of which tend to increase the longer it takes to resell
a foreclosed property ‒ and marketing and sales.




3
 A mortgage servicer, such as a commercial bank subsidiary or affiliate, may perform a variety of functions for an
Enterprise. These include collecting principal and interest payments from borrowers, forwarding the mortgage
payments to the owners of the loans, maintaining escrow accounts, and default-related services including
notifications to delinquent borrowers and, if necessary, initiating foreclosure proceedings.
4
 See generally, FHFA-OIG, Evaluation of FHFA’s Role in Negotiating Fannie Mae’s and Freddie Mac’s
Responsibilities in Treasury’s Making Home Affordable Program (EVL-2011-003, August 12, 2011), available at
http://www.fhfaoig.gov/Content/Files/EVL-2011-003.pdf.
5
  Lenders may also agree to a “short sale.” In a short sale scenario the homeowner conducts a private sale of the
house and the lender releases its lien in exchange for the proceeds of the sale despite the fact that they are
insufficient to pay off the debt. However, the lender may require the borrower to repay some or all of the remaining
mortgage debt at a later time. Alternatively, on some occasions a lender will accept a “deed in lieu of foreclosure.”
In such situations the homeowner will surrender title to the property voluntarily rather than require the lender to
initiate foreclosure proceedings.
6
 For more information regarding foreclosure, see FHFA-OIG, An Overview of the Home Foreclosure Process,
available at http://www.fhfaoig.gov/Content/Files/SAR%20Home%20Foreclosure%20Process.pdf.


           Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                          8
The key steps in the REO management process are intended to ensure that foreclosed properties
are:
        1. Secured to avoid theft, vandalism, and
           unauthorized use;                                              Negative Impacts of
                                                                          Foreclosures
        2. Maintained and repaired, e.g., lawns cut,                      Foreclosed and vacant properties
           plumbing winterized, hazards removed or                        can have profoundly negative
                                                                          consequences in the
           mitigated, leaking roofs fixed, etc. Ensuring                  neighborhoods and communities
           that a property is maintained in good repair                   in which they are located. These
           helps to protect its value and ensure its                      consequences include reduced
           marketability. Beyond protecting its                           property values. According to the
                                                                          U.S. Government Accountability
           investment, an Enterprise’s efforts in this
                                                                          Office, recent research has found
           regard minimize the negative impacts of                        that vacant foreclosed properties
           foreclosures on the communities in which                       may reduce prices of nearby
           they are located;7                                             homes by $8,600 to $17,000 per
                                                                          property in specific cities.
        3. Priced appropriately through broker price                      Additionally, vacant and
                                                                          unattended residential properties
           opinions or appraisals and satisfactory                        can attract crime, cause blight, and
           promotional efforts; and                                       pose a threat to public safety.

        4. Sold to homeowners or investors within a
           reasonable period.

Effective Contractor Oversight Is a Critical Component of the Enterprises’
REO Management Processes

The Enterprises’ REO inventories, which totaled nearly 180,000 properties at the end of 2011,
are located across the nation (see Figure 1).8




7
 See Government Accountability Office, Vacant Properties: Growing Number Increases Communities Costs and
Challenges (GAO-12-34, November 4, 2011), available at http://www.gao.gov/products/GAO-12-34.
8
 As discussed in more detail below, over 40% of the inventory is concentrated in five states: Michigan, California,
Florida, Illinois, and Georgia.


           Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                         9
Figure 1: Number of Enterprise REO Properties by State as of December 31, 20119




Rather than employing large staffs to manage their nationwide REO inventories directly, the
Enterprises generally rely on networks of thousands of contractors and subcontractors10 to
perform the day-to-day tasks associated with maintaining and selling foreclosed properties (see
Figure 2).11 Accordingly, it is critical that the Enterprises effectively oversee their contractors to
ensure that they mitigate REO-related expenses and the negative effects of foreclosures.




9
 Source: REO inventory data for the period ending December 31, 2011, as provided by Fannie Mae and
Freddie Mac.
10
  According to FHFA examinations, the Enterprises use approximately 10,000 contractors to perform REO-related
activities. FHFA-OIG cannot provide a reliable, comprehensive count of Enterprise contractors because some may
be employed by both Fannie Mae and Freddie Mac.
11
  Contractors may be compensated for their work through various methods, such as direct reimbursements by the
Enterprises for maintenance and repair activities.


          Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                      10
Figure 2: Enterprises’ General Oversight Structure for Their REO Contractors




The following summarizes the responsibilities of some key Enterprise REO contractors:

            Asset management firms: Each Enterprise has managers and staff members whose
             job it is to oversee the company’s REO contractors. In addition to their internal
             staffs, Fannie Mae and Freddie Mac also employ asset management firms to direct
             certain REO contractors in the performance of day-to-day property management
             responsibilities. However, the ultimate responsibility for the management and
             oversight of the contractor networks rests with the Enterprises’ senior managers;

            Real estate brokers: Instead of, or in addition to, hiring asset management firms, the
             Enterprises may place brokers under contract to manage selected portions of their
             inventory all through the REO process, i.e., from inspecting and securing a property
             to disposing of it by sale. Their contractual duties may include identifying and
             mitigating hazardous conditions at the properties, developing and implementing
             marketing plans, listing properties, and evaluating offers;




           Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                      11
                Attorneys: The Enterprises contract with attorneys in the states in which their
                 properties are located to accomplish a variety of legal tasks.12 For example, attorneys
                 may manage the eviction process when necessary. Further, designated attorneys and
                 national title companies are employed to ensure that the Enterprises obtain title to
                 properties incident to foreclosure sales and to manage the closing process upon resale;

                Property maintenance companies and repair contractors: These contractors
                 secure and maintain properties by, among other things, removing interior and exterior
                 debris, cleaning houses, cutting lawns, inspecting and repairing plumbing, and
                 winterizing structures. They also make repairs, such as fixing leaking roofs, repairing
                 or replacing appliances, and installing major systems, such as heating and air
                 conditioning units; and

                Appraisers and broker price opinion firms: These contractors help the Enterprises
                 determine the value and listing prices of foreclosed properties by reviewing
                 comparable sales and conducting appraisal reviews.

The Enterprises can employ a variety of controls and systems to help ensure effective contractor
performance and minimize the costs associated with their contractor networks. These measures
include the following:13

           1. Hiring qualified REO contractors, such as law firms, property maintenance
              companies, real estate brokers, and others to secure, maintain, market, and sell
              REO properties.

           2. Providing contractor training as necessary or appropriate.

           3. Establishing standard policies and procedures for key REO maintenance
              activities, such as the number of times per month lawns must be cut.

           4. Establishing budgets and reimbursement schedules for routine property
              maintenance activities.

           5. Requiring multiple bids and/or reviews for proposed repairs that exceed pre-
              established dollar thresholds.



12
  For a discussion of FHFA’s oversight of the attorneys Fannie Mae uses in the foreclosure and related processes,
see FHFA-OIG, FHFA’s Oversight of Fannie Mae’s Default Related Legal Services (AUD-2011-004, September
30, 2011), available at http://www.fhfaoig.gov/Content/Files/AUD-2011-004.pdf.
13
     The procedures employed by the two Enterprises may not be identical.


               Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                          12
       6. Conducting on-site inspections of selected properties to ensure that they are
          secured, maintained, and repaired according to established standards.

       7. Requiring multiple broker price opinions or appraisals to establish listing
          prices and reviewing proposed prices as appropriate.

       8. Conducting audits of bills submitted by contractors to ensure their
          appropriateness and screen for potential fraud.

       9. Conducting account reviews and performance management audits and
          monitoring contractors using established metrics, including contractual
          obligations.

       10. Withholding payments to contractors for services rendered until such services
           have been completed satisfactorily and suspending or terminating
           unsatisfactory contractors.

An Enterprise’s failure to effectively manage its contractors’ implementation of basic REO
responsibilities, i.e., securing, maintaining, repairing, and marketing properties, would place it at
considerable financial risk. It could also endanger the stability of the communities in which the
properties are located. For example, if a contractor fails to secure properties for which it is
contractually responsible, then the properties may be broken into, looted, and used for illegal
activities. Similarly, a contractor’s failure to maintain a property, e.g., remove debris, cut lawns,
fix broken windows, etc., can reduce its value and detract from its marketability, as well as the
marketability of near-by homes. The deteriorated condition of an REO property may cause it to
remain on the market and in an Enterprise’s inventory for an extended period, thereby increasing
the Enterprise’s total carrying costs. This, in turn, will reduce the Enterprise’s returns on the sale
of such properties and, ultimately, increase the taxpayer costs associated with the
conservatorships.

The Enterprises also must implement REO management controls and strategies to ensure that:

      The fair market values of their foreclosed properties are established. If fair market
       values are not established effectively, then properties may be sold at unreasonably low
       prices that expose the Enterprises and taxpayers to unnecessary losses;

      Foreclosed properties located in economically distressed areas are managed and
       marketed in a cost-effective manner. It may be particularly difficult to sell properties
       located in such areas given potentially weak real estate markets. In some cases, it may
       not be cost-effective for an Enterprise to maintain, repair, and sell a deteriorated
       foreclosed property in such areas. Indeed, it may be more cost-effective in some cases to
       demolish such properties; and
         Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                    13
        Foreclosed property repairs are cost-effective. In some cases, repairs may enhance a
         property’s value and thereby maximize returns. However, without an effective means to
         make determinations about whether repairs will enhance property value, the Enterprises
         could potentially reimburse contractors for repairs that are unnecessary and increase their
         property management costs.
                                                                            FHFA-OIG Hotline
Finally, there is also the risk of considerable fraud and                   FHFA-OIG investigates
                                                                            allegations of fraud and other
abuse associated with the failure to manage Enterprise
                                                                            misconduct involving the
REO contractors effectively. Under the best of                              operations of FHFA and the GSEs,
circumstances it may be challenging for the Enterprises to                  including REO-related matters.
verify that certain types of maintenance and repairs, such                  FHFA-OIG’s Hotline allows
as interior painting and plumbing, are being completed in                   concerned parties to report
                                                                            allegations of fraud, waste, or
accordance with quality standards and within established                    abuse to FHFA-OIG directly and
timeframes for thousands of foreclosed properties across                    confidentially. The FHFA-OIG
the nation. Therefore, it is important for the Enterprises to               Hotline can be reached at 1 (800)
establish effective property inspection procedures and                      793-7724 or via email at
                                                                            oighotline@fhfaoig.gov.
controls to prevent fraudulent contractor reimbursements.

The Enterprises Face Significant Challenges and Risks in Managing Their
REO Inventories

The Enterprises have experienced extraordinary increases in their REO inventories and the costs
associated with them since the onset of the U.S. housing and financial crises starting in 2007 and
2008. Further, given ongoing delays in the foreclosure process and the financial distress in
which millions of American homeowners continue to find themselves, the Enterprises are likely
to face elevated REO inventories and costs for years to come.

The following highlights some of the REO-related risks facing the Enterprises.

         Managing the Ongoing and Expected Surge in Foreclosed Property Inventories

Foreclosed property inventories have grown rapidly since 2007. According to Enterprise data,
Fannie Mae’s and Freddie Mac’s combined REO inventory nearly quintupled from about 48,100
units at the end of 2007 to 234,582 units at the end of 2010 (see Figure 3). In 2011, the
Enterprises’ combined REO inventory declined by 25% to more than 179,000 units, which was
still more than three times higher than the 2007 level.14



14
  This decline continued in the first quarter of 2012 with the Enterprises’ combined REO inventories falling by
approximately 3% from 179,083 properties to 173,480 properties.


           Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                        14
Figure 3: Enterprises’ REO Inventories, 2007-201115




By some measures, Fannie Mae and Freddie Mac responded effectively to the surge in
foreclosures by successfully augmenting their disposition capacities, but the recent decrease in
REO inventory is also influenced by lagging acquisitions in late 2010 and 2011. The
Enterprises’ rate of disposition of foreclosed properties, which generally refers to sales, appears
to have largely kept up with the surge in foreclosures as shown in Figure 4.16 Specifically, the
Enterprises disposed of 353,851 properties in 2011 as compared to 57,748 in 2007. This
represents a nearly six-fold increase in the total number of dispositions. Further, FHFA-OIG’s
analysis indicates that the rate at which the Enterprises disposed of REO properties increased
from about 52% in 2008 to 66% in 2011. In other words, the Enterprises disposed of the
equivalent of slightly more than half of their annual foreclosed property inventories in 2008, but

15
  See Fannie Mae, 2008 10-K Report, at 187, available at www.fanniemae.com/portal/about-us/investor-
relations/sec-filings.html, and 2011 10-K Report, at 168, available at www.fanniemae.com/portal/about-us/investor-
relations/sec-filings.html; Freddie Mac, 2008 10-K Report, at 160, available at
www.freddiemac.com/investors/sec_filings/index.html, and 2011 10-K Report, at 167, available at
www.freddiemac.com/investors/sec_filings/index.html. Freddie Mac did not publish a breakdown of its multifamily
inventory data in its annual filings for 2007 and 2008. For consistency across the years, FHFA-OIG has included
Freddie Mac’s multifamily inventory in this data. The impact upon Freddie Mac’s total REO volume is likely to be
negligible: for the years 2009 to 2011, the multifamily inventory comprised less than 0.05% of all REO units and
never exceeded 20 properties.
16
  The Enterprises also dispose of distressed properties through sales to cities, municipalities, and other public
entities; bulk sales and public auctions; and direct sales to Neighborhood Stabilization Program grant recipients.


           Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                          15
by 2011 they had successfully increased their sales to about two-thirds of their inventory. This is
significant because, absent this increase in their REO dispositions, Enterprise REO inventories
would be much higher than they are now.17 FHFA-OIG also observes, though, that the rate at
which the Enterprises acquired foreclosed properties into their REO inventories declined by 23%
in 2011, and that this may have facilitated the increase in their disposition performance from
55% in 2010 to 66% in 2011.

Figure 4: Enterprises’ REO Acquisition and Disposition Performance, 2007-201118

               REO Inventory                     2007          2008          2009           2010           2011
     Acquisitions                               71,961        145,183       230,729        388,994        298,352
     Dispositions                               57,748        100,422       192,406        286,959        353,851
     Year-end Inventory                         48,123        92,884        131,207        234,582        179,083
     Disposition Rate                           54.5%          51.9%         59.5%          55.2%          66.4%


Fannie Mae attributed delays in its acquisition of REO properties in 2011 to new legislative,
regulatory, and judicial requirements pertaining to foreclosures. Additionally, Fannie Mae noted
that it is contributing to the delay by directing its servicers to defer foreclosure sales until they
verify that the borrowers are ineligible to participate in Treasury’s Home Affordable Mortgage
Program and that all other home retention and foreclosure prevention alternatives have been
exhausted. In addition, Freddie Mac stated that in late 2010 several large mortgage
seller/servicers temporarily suspended foreclosure proceedings in several states due to potential
legal deficiencies in such proceedings.19 Freddie Mac added that, although the larger



17
  FHFA-OIG estimates that if the Enterprises’ disposition rate had remained constant at the 2008 rate of 51.9%,
then their combined REO inventories would have reached 269,072 properties in 2011 rather than the actual amount
of 179,083. This is significant because larger REO inventories can result in increased Enterprise REO costs.
18
  See Fannie Mae, 2008 10-K Report, at 187, available at www.fanniemae.com/portal/about-us/investor-
relations/sec-filings.html, and 2011 10-K Report, at 168, available at www.fanniemae.com/portal/about-us/investor-
relations/sec-filings.html; Freddie Mac, 2008 10-K Report, at 160, available at
www.freddiemac.com/investors/sec_filings/index.html, and 2011 10-K Report, at 167, available at
www.freddiemac.com/investors/sec_filings/index.html. See footnote 15 for an explanation of the inclusion of
Freddie Mac multifamily REO properties.
The disposition rate is the proportion of the Enterprise’s annual REO inventory that is disposed of in the given year.
The ratio – calculated as the current year dispositions divided by the sum of the inventory at the end of the previous
year and the current year acquisitions – provides a rough measure of REO performance but it has limitations. For
example, the metric does not account for factors that may slow the turnover rate, such as state-mandated redemption
periods, tenant protections laws, properties requiring eviction, or other constraints to marketing the properties.
19
  For example, some law firms that process foreclosures under contract with the Enterprises appear to have filed
false affidavits or documents with forged signatures in foreclosure proceedings.


            Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                         16
seller/servicers generally resumed foreclosure proceedings in early 2011, the foreclosure process
continued to experience delays throughout 2011.

Further, general distress in the housing sector will likely continue to result in elevated REO
inventories. For example, the Enterprises’ financial data indicate that, as of the end of 2011,
more than 1.1 million mortgages held or guaranteed by the Enterprises were “seriously
delinquent,” i.e., were 90 or more days past due. At that time, the volume of seriously
delinquent mortgages was more than six times the size of the Enterprises’ REO inventories (see
Figure 5).

Figure 5: Enterprise Single-Family REO Inventories and Mortgages More Than 90 Days
Delinquent, December 31, 201120

                                                                            Ratio of Mortgages More Than
                      Mortgages More Than 90          Properties in REO      90 Days Delinquent to REO
      Enterprise        Days Delinquent21                Inventory                    Inventory
     Fannie Mae              690,139                      118,528                       582%

     Freddie Mac               412,988                      60,535                        682%

     Combined                 1,103,127                     179,063                       616%


FHFA-OIG did not independently estimate the extent to which the level of seriously delinquent
mortgages could increase the Enterprises’ REO inventories over time. Nevertheless, the
Enterprises’ data suggest that the numbers could be significant given the extent to which many
borrowers are behind on their mortgage payments. For example, there were 558,761 mortgages
either owned or guaranteed by the Enterprises that were a year or more delinquent at the end of
2011 (see Figure 6). Indeed, Fannie Mae has stated that, due to elevated numbers of delinquent
borrowers among other challenges in the housing sector, it does not expect its REO inventory to
return to pre-financial crisis levels for “years.”22




20
  See FHFA, Foreclosure Prevention & Refinance Report, Fourth Quarter 2011, at 43-45, available at
http://www.fhfa.gov/webfiles/23522/4q11_fpr_finalv2i.pdf.
21
  FHFA-OIG calculation based on Federal Housing Finance Agency, Foreclosure Prevention & Refinance Report,
Fourth Quarter 2011, at 43-45.
22
  See Fannie Mae, 2011 10-K Report, at 17, available at www.fanniemae.com/portal/about-us/investor-
relations/sec-filings.html.


            Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                       17
Figure 6: Enterprise Single-Family Mortgages, by Length of Delinquency, December 31,
201123

                    365+ Days            180-364 Days            90-179 Days          Total Mortgages More Than
 Enterprise         Delinquent            Delinquent             Delinquent              90 Days Delinquent24
Fannie Mae           351,612               173,462                 165,065                     690,139
Freddie Mac           207,149               105,010                100,829                       412,988
Combined              558,761               278,472                265,894                      1,103,127


         Managing Concentrations of Foreclosed Properties in States with Particularly
         Distressed Real Estate Markets

The Enterprises also face significant challenges in mitigating their REO-related losses in states
with large concentrations of foreclosed properties. The five states with the largest concentrations
of Enterprise REO all experienced double-digit declines in overall house prices from 2007
through 2011. According to FHFA’s House Price Index (HPI) both California and Florida
experienced declines of 44% (see Figure 7).25 Other states with relatively large percentages of
the Enterprises’ REO inventories that have experienced substantial declines in house prices
include Arizona at 48% and Nevada at 59%. With large concentrations of their REO inventories
located in states with such dramatic house price declines, it is reasonable to expect that the
Enterprises may face challenges in selling foreclosed properties in them as compared to other
regions. Further, depressed real estate markets in these states could limit the Enterprises’
capacity to mitigate their overall credit losses.26




23
  See FHFA, Foreclosure Prevention & Refinance Report, Fourth Quarter 2011, at 44 and 45, available at
http://www.fhfa.gov/webfiles/23522/4q11_fpr_finalv2i.pdf.
24
  FHFA-OIG calculation based on FHFA, Foreclosure Prevention & Refinance Report, Fourth Quarter 2011, at
43-45.
25
  FHFA produces quarterly house price indexes using Enterprise data for conventional conforming loans for single-
family detached properties. The indexes are based on a modified weighted-repeat sales methodology developed by
Case and Shiller. See OFHEO House Price Indexes: HPI Technical Description, available at
http://www.fhfa.gov/webfiles/896/hpi_tech.pdf.
26
  As discussed previously, the Enterprises recognize mortgage loan losses at the foreclosure sale, but there are also
costs involved in REO management such as maintenance expenses. In states with distressed markets, the
Enterprises may face further declines in the values of foreclosed properties in their REO inventories that would
increase their overall credit losses.


           Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                         18
Figure 7: States with the Highest Number and Percentage of Enterprise Single-Family
REO Properties27

                                                                Percentage of             Change in House Prices
            State                  REO Properties             National Inventory             from 2007-2011
Michigan                              22,605                        12.6%                        -26.5%
California                             19,972                         11.2%                        -44.2%
Florida                                12,618                         7.0%                         -44.8%
Illinois                               12,471                         7.0%                         -20.3%
Georgia                                11,962                         6.7%                         -25.1%
Minnesota                               8,765                         4.9%                         -20.9%
Ohio                                    7,503                         4.2%                         -13.8%
Texas (a)                               6,782                         3.8%                          3.5%
Arizona                                 6,070                         3.4%                         -47.9%
Washington                              4,854                         2.7%                         -23.9%
Nevada                                  4,206                         2.3%                         -59.0%
Wisconsin                               3,955                         2.2%                         -12.3%
Missouri                                3,937                         2.2%                         -12.2%
North Carolina                          3,887                         2.2%                         -10.5%
Virginia                                3,550                         2.0%                         -16.3%
Total (b)                              133,137                        74.4%                        -24.9%


To illustrate further the risks associated with the Enterprises’ REO inventories in these states,
Figure 8 shows the locations of their 22,534 foreclosed properties in Michigan at the end of
2011.28 These properties were generally located in the lower half of the state, with the bulk


27
  Source: FHFA, State HPI Summary, available at www.fhfa.gov/Default.aspx?Page=215&Type=summary; and
FHFA, Foreclosure Prevention & Refinance Report, Fourth Quarter 2011, at 43, available at
http://www.fhfa.gov/webfiles/23522/4q11_fpr_finalv2i.pdf.
(a)
  REO properties in Texas comprise a relatively large percentage of the Enterprises’ national REO inventory given
the large number of Enterprise-owned mortgages in the state. However, the percentage of Enterprise-owned
mortgage loans in Texas that actually entered into foreclosure and became REO properties is relatively small
compared to other states, i.e., Texas ranks 36th out of the 50 states in terms of the percentage of Enterprise-owned
mortgage loans that have entered into the Enterprises’ REO inventories.
(b)
  The “Total” row is comprised of the total REO properties in the selected states, their percentage of the
Enterprises’ national REO inventory, and the average of the five-year change in the FHFA HPI for those states.
28
  This figure was derived from loan-level data for REO properties provided to FHFA-OIG by the Enterprises.
Publicly available sources, such as FHFA’s Foreclosure Prevention & Refinance Report for the Fourth Quarter of


             Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                         19
concentrated in southeast Michigan in and around Detroit. In recent years, the Detroit area has
faced significant economic challenges, such as relatively high unemployment, due to weakness
in the auto sector.

Figure 8: Enterprises’ Combined Single-Family REO Inventories in Michigan (Number of
Properties by City), December 31, 201129




As of the end of 2011, Enterprise REO properties within Detroit were concentrated in areas with
vacancy rates at or exceeding 18% (see dark shaded areas in Figure 9). When vacant properties
are inadequately secured they become particularly vulnerable to unauthorized entry and
vandalism, and contribute to urban blight. Further, they can serve as a focus for illegal
activities.30 This, in turn, further hurts the housing market and can adversely affect the values of
nearby properties.


2011, indicate that the Enterprises REO inventory in the state of Michigan consisted of 22,605 properties at the end
of 2011.
29
   Figures 8 and 9 were developed using the ArcGIS online tool. FHFA-OIG normalized and validated Enterprise-
provided loan-level REO data for the period ending December 31, 2011. The REO data is displayed on the maps
using a combination of property addresses, zip codes, city locations, and latitudinal and longitudinal coordinates.
30
 See Government Accountability Office, Vacant Properties: Growing Number Increases Communities’ Costs and
Challenges (GAO-12-34, November 4, 2011), available at http://www.gao.gov/products/GAO-12-34.


           Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                         20
Figure 9: Enterprises’ Combined REO Inventory Concentrations by Property Vacancy
Rates in Detroit, Michigan, December 31, 201131




        Managing REO Inventories in States with Redemption Laws

Another challenge facing the Enterprises is the effect that some states’ redemption laws may
have on their ability to maintain and market their foreclosed properties. As FHFA-OIG recently
noted, 29 states and the District of Columbia have redemption laws. These laws permit
borrowers to remain in foreclosed properties for a specified time after the foreclosure sale has
been completed (generally ranging from 5 days up to 3 years, depending on the state).32 The
intent of these laws is to provide former homeowners who have been foreclosed upon with an
opportunity to redeem the property by paying the loan debt and the cost of the foreclosure sale or
an amount specified in state statute. During these redemption periods the former homeowners
generally may remain in the properties, and the Enterprises may not evict them and secure the

31
  Figure 9 displays individual REO properties from the Enterprises’ inventories as of December 31, 2011, and
property vacancy rates by census block group from the 2010 census. Housing vacancy rates are publicly available
from the U.S. Census Bureau at http://www.census.gov/hhes/www/housing/hvs/hvs.html. Aggregate data for
Enterprise REO properties by census block group were not available at the time of publication.
32
  See FHFA-OIG, An Overview of the Home Foreclosure Process, at 19-21, available at
http://www.fhfaoig.gov/Content/Files/SAR%20Home%20Foreclosure%20Process.pdf.


          Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                       21
properties.33 Thus, the Enterprises may place properties that are subject to redemption in what is
known as “unable to market for sale” status.

State redemption laws can have a significant impact on the Enterprises’ ability to maintain and
market their foreclosed properties.34 Fannie Mae has said that, as of the end of 2011, 12% –
nearly 15,000 of 118,528 – of its inventory of foreclosed properties were occupied as a result of
redemption laws. Fannie Mae has also said that state redemption laws increase the time that a
property remains in its REO inventory by an average of two to six months.

In spite of the adverse impact of such laws, FHFA has not challenged their application to the
Enterprises. In contrast, on December 12, 2011, FHFA filed a lawsuit in the U.S. District Court
for the Northern District of Illinois, challenging the impact of the City of Chicago’s “Vacant
Buildings Ordinance” as enforced against the Enterprises. The ordinance seeks to address the
problem of vacant properties by requiring mortgage owners to inspect mortgaged properties
monthly in order to determine whether they are vacant, in which case the mortgage owners must
pay fees of $500 per property to register them as such. FHFA contends that the ordinance
subjects the Enterprises to regulation and supervision by the Chicago Department of Buildings.

         Managing REO-Related Costs and Expenses

The surge in REO inventories during the period of 2007 through 2011 produced a dramatic
increase in the Enterprises’ REO-related costs, which cumulatively total $8.5 billion (see Figure
10). These costs, which include maintenance and other property management expenses, jumped
from $649 million in 2007 to nearly $3 billion in 2008. Subsequently, these expenses have
fluctuated, falling to $1.1 billion in 2009, rising to $2.4 billion in 2010, and falling to $1.4 billion
in 2011. The Enterprises’ REO expenses in 2011 were offset, in part, by recoveries on mortgage
repurchase settlements with certain seller/servicers and other recoveries.35




33
  It is uncommon for foreclosed property owners to come up with the cash necessary to redeem their properties
during the redemption period, but the right is exercised from time to time. See FHFA-OIG, An Overview of the
Home Foreclosure Process, at 15, available at
http://www.fhfaoig.gov/Content/Files/SAR%20Home%20Foreclosure%20Process.pdf.
34
  There are steps that the Enterprises can take to mitigate the risks associated with foreclosed properties subject to
redemption laws. For example, Freddie Mac said it monitors properties during redemption periods and attempts to
shorten such periods by offering cash for redemption and monitoring for vacancy. If the property becomes vacant,
Freddie Mac may file an affidavit of abandonment or execute other applicable processes within a state.
35
  Under the terms of their mortgage purchase contracts, the Enterprises may require mortgage sellers to repurchase
mortgages that contain certain defects, such as inadequate documentation of borrower income. Such repurchase
claims may be used to offset credit losses.


           Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                          22
Figure 10: Enterprise Single-Family REO Operations Expenses (in Millions), 2007-201136

                  Enterprise        2007         2008        2009         2010         2011         Total
                 Fannie Mae         $444        $1,844       $857        $1,680        $765        $5,590
                 Freddie Mac        $205        $1,097       $287         $676         $596        $2,861
                 Total              $649        $2,941      $1,144       $2,356       $1,361       $8,451


FHFA Oversight of Enterprise REO Management

The Agency did not conduct targeted examinations of REO management from 2008 to early
2011, despite the surge in Enterprise REO inventories during this critical period. In a previous
evaluation report, FHFA-OIG noted that FHFA recognized that the Enterprises’ growing
inventories of REO represent an important risk, but the Agency suffered from a shortage of
examiners which limited its capacity to examine the Enterprises’ REO management controls.37

In early 2011, FHFA reorganized its examination program and initiated a process to hire
additional examiners. In its 2011 examination planning, the Agency included the Enterprises’
management and oversight of their REO contractors, as well as other REO management issues as
examination topics.38 FHFA completed its examination work at both Enterprises by March
2012.




36
  Source: Fannie Mae 10-K (Annual Report) for Year Ended December 31, 2011 and Fannie Mae 10-K (Annual
Report) for Year Ended December 31, 2009; Freddie Mac 10-K (Annual Report) for Year Ended December 31,
2011 and Freddie Mac 10-K (Annual Report) for Year Ended December 31, 2009.
The expenses denoted in the figure above contain the following elements:
                Maintenance, repair, and other costs;
                Valuation allowances, i.e., increase or decrease in the fair market value of properties in REO
                 inventory;
                Disposition gains or losses; and
                Recoveries from mortgage insurance, pool insurance, or seller/servicer repurchases (Freddie Mac
                 reported $634 million in such recoveries in 2011, but Fannie Mae did not report any).
37
  See FHFA-OIG, Evaluation of Whether FHFA Has Sufficient Capacity to Examine the GSEs (EVL-2011-05,
September 22, 2011), available at http://www.fhfaoig.gov/Content/Files/EVL-2011-005.pdf.
38
     FHFA-OIG is currently conducting an audit of FHFA’s supervisory risk-assessment for REO.


               Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                             23
FHFA’s examinations identified deficiencies in key REO contractor management controls at
both Enterprises. These included, among others, deficiencies in controls relating to:

            The selection of REO contractors, e.g., one Enterprise did not perform comprehensive
             background checks on its contractors;

            The compensation of REO contractors that exposes the Enterprises to improper
             reimbursement of contractors. For example, the Enterprises lacked controls to protect
             adequately against duplicative reimbursements for REO-related work; and

            REO contractor performance, such as tracking complaints and corrective actions. For
             example, one Enterprise did not inspect a sufficient number of properties to determine
             how well its contractors maintain its REO inventory, and the other lacked adequate
             REO contractor oversight processes to protect it against inappropriate property
             maintenance and unnecessary repairs.

As a result of these REO examinations, FHFA issued what are known as Matters Requiring
Attention (MRA) to the Enterprises to remediate certain identified deficiencies. MRAs require
the Enterprises to remediate such deficiencies within specified periods.

FHFA officials said that they plan to monitor the Enterprises’ REO management during 2012. In
particular, they plan to verify the Enterprises’ implementation of the MRAs instituted pursuant to
the recently completed examinations discussed above. Additionally, FHFA plans to conduct
supplemental REO examinations of the Enterprises to determine the adequacy of their
procedures and controls for determining the fair value of foreclosed properties prior to their
disposition.

FHFA’s and Fannie Mae’s Pilot Program Is Testing the Concept of Selling in
Bulk Foreclosed Properties with Rental Commitments

In its role as the Enterprises’ conservator, FHFA has been working with them to develop and test
alternative approaches to addressing the ongoing risks and costs associated with the surge in
REO inventories. In particular, FHFA is overseeing Fannie Mae’s development and
implementation of a pilot program under which investors will have the opportunity to purchase
nearly 2,500 foreclosed properties in bulk, conditioned on their agreement to operate the
properties as rentals for a period of years. FHFA and Fannie Mae consider the REO pilot
program to be an opportunity to:

            Assess investor interest in purchasing a new type of foreclosed property asset, i.e.,
             scattered site single-family rental housing.


           Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                      24
             Determine whether the disposition of foreclosed properties in bulk, as opposed to
              individual retail sales, presents an opportunity to improve housing market conditions.

             Determine whether selling foreclosed properties in bulk as rental units can be
              replicated by the Enterprises and other financial institutions.

Fannie Mae’s approximately 2,500 properties, which will be included in the first phase of the
program, are located in metropolitan areas as well as regions of states with particularly distressed
real estate and housing markets (see Figure 11).39 As discussed earlier, Michigan, California,
Florida, Illinois, Georgia, Arizona, and Nevada have large concentrations of Enterprise REO
properties and, according to FHFA’s HPI, experienced double-digit declines in overall house
prices from 2007 through 2011. FHFA officials said that the pilot program will be focused on
such distressed areas and that they seek to determine whether bulk sales of properties can be used
to complement traditional retail sales.

Figure 11: Preliminary Summary of Fannie Mae REO Assets Available Through the REO
Pilot Program, as of February 27, 201240

               Location of REO Properties in Fannie         Property        Percentage of Pilot
                       Mae Pilot Transaction                 Count           Transaction Total
               Atlanta, GA                                    572                 23.0%
               Chicago, IL                                      99                 4.0%
               Florida - Central and Northeast                 190                 7.6%
               Florida - Southeast                             418                 16.8%
               Florida - West Coast                            167                 6.7%
               Las Vegas, NV                                   219                 8.8%
               Los Angeles / Riverside, CA                     484                 19.4%
               Phoenix, AZ                                     341                 13.7%
               Total                                          2,490               100.0%




39
  FHFA announced the initiation of the pilot program in February 2012. See FHFA, FHFA Announces Interested
Investors May Pre-Qualify For REO Initiative (Feb. 1, 2012), available at
www.fhfa.gov/webfiles/23196/REO2112F.pdf; and FHFA, FHFA Announces Pilot REO Property Sales in Hardest-
Hit Areas (Feb. 27, 2012), available at www.fhfa.gov/webfiles/23403/REOPR22712F.pdf.
40
  See FHFA, Preliminary Summary of Assets: REO Initiative Fannie Mae Pilot Transaction (SFR REO 2012),
available at www.fhfa.gov/webfiles/23402/FNMASFRREO2012-1SummaryofAssets.pdf.


            Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                       25
FHFA and Fannie Mae officials said that the REO properties offered for sale under the pilot
program have been pooled so that the bidders can place one of two permissible types of offers on
them:

              An outright purchase of 100% of the properties in the pool; or

              Joint ventures between the bidder and Fannie Mae that include equity sharing
               arrangements.41

A senior Fannie Mae official also said that FHFA would compare the bids made through the pilot
program with those made on similar properties through the traditional retail sales route to
determine which approach is the most cost-effective. This process is expected to be completed
in the summer of 2012.

         Potential Risks Associated with the Pilot Program

Although the REO pilot program may demonstrate that there are benefits to selling in bulk
foreclosed properties with rental commitments, FHFA-OIG notes that there also appear to be
potential risks associated with it that must be addressed. These include the risks that:

              Fannie Mae and FHFA may not have sufficient data or, in some cases, the technical
               capacity to appropriately determine whether proceeding with bulk property sales with
               rental commitments is a workable, cost-effective strategy for disposing of REO that is
               consistent with the objectives of the conservatorship. For example, there is a risk that
               Fannie Mae and FHFA may lack the capacity to determine generally whether or not
               such bulk sales maximize financial returns as compared to traditional individual sales
               of foreclosed properties;

              FHFA and Fannie Mae may not have selected appropriate regions or housing markets
               in which to operate the program. For example, the regions or specific housing
               markets selected may be in the process of recovering, and therefore, traditional
               property sales with or without rental commitments may be more cost-effective than
               bulk sales with rental commitments;

              Investors may engage in misconduct, or even fraud, in order to participate in the
               program. For example, investors may misrepresent their financial or technical
               capacity to manage scattered rental units. Thus, Fannie Mae’s joint venture partners
41
  Under Fannie Mae’s joint venture structures, including equity sharing arrangements, the investor and Fannie Mae
will share a financial ownership interest in the properties. However, the investor, or joint venture partner or
member, assumes responsibility for all aspects of the properties, including their maintenance and management as
rental units. Fannie Mae will receive a portion of the rental income for its interest in the joint venture arrangement.


             Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                          26
             could prove ineffective in managing rental units, or otherwise default on their
             commitments under the program;

            Fannie Mae may lack the infrastructure necessary to monitor the program’s
             implementation. For example, Fannie Mae does not typically involve itself with
             foreclosed properties after they are sold through its traditional REO management
             processes. However, the REO pilot program requires Fannie Mae to monitor
             properties after their sale for, among other things, compliance with established rental
             commitments and the treatment being afforded to tenants; and

            FHFA may lack the resources to conduct adequate oversight to ensure that
             Fannie Mae manages the program effectively.

       Controls Being Developed to Mitigate Potential Risks

FHFA and Fannie Mae officials said that they recognize the potential risks associated with their
bulk sale with rental commitment approach. However, they also said that they either have
implemented or are developing a number of controls to mitigate such risks. According to these
officials and Fannie Mae’s program documentation, these controls include:

            Stringent investor requirements pertaining to their financial and operational
             expertise and technical qualifications to acquire and manage rental properties:
             FHFA officials said they developed an extensive investor application form in
             connection with this pilot program. Bidders are required to pass a rigorous evaluation
             process in order to bid. A deposit of $250,000, along with signed non-disclosure
             agreements, is required to view the property-level information. Fannie Mae has also
             hired a financial firm to advise it on the structure of the REO pilot program, and a
             firm to review investor bidder applications;

            Extensive monitoring of investors’ management of purchased properties and
             compliance with their rental commitments: Fannie Mae plans to require joint
             venture partners to provide it with extensive financial data, including consolidated
             income and expense statements; information concerning their tenants; and their rent
             rolls. A Fannie Mae official said that the Enterprise also may conduct inspections of
             properties that have been sold through bulk sales to ensure that the investors are
             meeting their rental commitments and maintaining the properties appropriately; and

            Ongoing oversight: FHFA plans to review Fannie Mae’s implementation and
             oversight of the REO pilot program and any additional bulk sales with rental
             commitments on an ongoing basis. This oversight will include consideration of


           Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                      27
           appropriate enforcement actions and applicable legal remedies for contract non-
           compliance or default.

Although FHFA and Fannie Mae are developing or implementing such controls, their
effectiveness remains to be seen. As described in the next section of this report, FHFA-OIG
plans to evaluate the controls and other issues associated with the REO pilot program if it is
expanded over time.




         Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                    28
FHFA-OIG’S STRATEGY FOR ASSESSING
FHFA’S OVERSIGHT OF THE ENTERPRISES’
REO MANAGEMENT
Given the risks associated with the Enterprises’ REO management, FHFA-OIG is implementing
a proactive audit and evaluation strategy under which it will assess the Agency’s related
oversight and conservatorship efforts. It is intended to determine whether the Agency and the
Enterprises manage REO to maximize financial recoveries and minimize the negative effects of
foreclosures on affected communities. FHFA-OIG also plans to assess the effectiveness of the
REO pilot program should the Agency and the Enterprises decide to implement it on a wider
scale. In this regard, FHFA-OIG will analyze its potential effectiveness and determine whether
proper risk management controls are in place to prevent fraud and abuse.

FHFA-OIG’s REO strategy consists of the following:

     1. Several Ongoing Audits of FHFA’s Oversight of the Enterprises’ REO Management
        Programs

FHFA-OIG is presently conducting two audits of FHFA’s oversight of the Enterprises’ REO
management programs.42 The audits are focused on the Enterprises’ oversight of basic REO
management functions, including acquisition, valuation, maintenance, marketing, and
disposition.

The specific objectives of these REO audits are to:

              Assess FHFA’s oversight of the performance of the Enterprises’ REO contractors,
               including compliance with Enterprise guidelines, and property management and
               marketing policies and procedures;

              Conduct tests on a sample of properties to determine error rates, e.g., the rate of
               erroneous, duplicative, and otherwise unnecessary payments; and

              Determine the risk of fraud associated with payments for services rendered and
               property management associated with the foreclosure process.

FHFA-OIG also is conducting an audit of FHFA’s REO risk assessment processes.

42
 One audit covers FHFA’s REO management oversight efforts at Fannie Mae and the other at Freddie Mac.
FHFA-OIG will issue a separate report for each of these audits, and it will issue an additional report that summarizes
FHFA-OIG’s overall findings.


             Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                         29
   2. Potential Evaluations Related to Impacts of FHFA’s Oversight of the Enterprises’
      REO Management Programs

In planning evaluations, FHFA-OIG intends to cover the key steps in the REO management
process, including matters such as securing the property, maintenance and repair, valuation and
marketing, and sale. FHFA-OIG is considering several evaluations of FHFA’s oversight of the
Enterprises’ planning, monitoring, and management of REO, with a focus on their ability to
handle future workloads and mitigate adverse impacts on homeowners and communities.

The specific objectives of these REO evaluations would be to assess FHFA’s oversight of the
Enterprises’:

            Management systems, risk controls, and capacity to deal with any surge of
             foreclosures in the Enterprises’ REO inventories due to seriously delinquent
             mortgages;

            Efforts to mitigate the effects of concentrations of REO inventories and abandoned or
             vacant foreclosed properties in economically distressed areas of the country; and

            Initiatives to manage foreclosed properties occupied under state or local redemption
             and homesteading laws or regulations.

   3. Evaluation of Any Expanded Bulk Sale REO Program

FHFA-OIG also plans to evaluate FHFA’s and Fannie Mae’s REO pilot program should FHFA
decide to implement the bulk sale/rental commitment model on a wider scale.

The areas that FHFA-OIG may cover in such an evaluation include:

            Whether the program is achieving key expected outcomes and the quality of the data
             and analytics FHFA and Fannie Mae use to make such determinations. For example,
             the evaluation could cover FHFA’s and Fannie Mae’s basis for determining whether,
             in certain cases, it is more cost-effective to proceed with the bulk sale with rental
             commitment model than to make sales through the traditional retail channel;

            The quality of the controls that are established to ensure that investors have sufficient
             expertise and financial resources to meet their rental commitments, as well as
             Fannie Mae’s and FHFA’s efforts to ensure compliance with these controls;

            The quality of the processes by which Fannie Mae monitors investor compliance with
             their rental commitments and the restrictions on the number of properties that may be
             sold annually, as well as FHFA’s oversight of the Enterprises’ processes;

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            FHFA’s and Fannie Mae’s program enforcement efforts to ensure compliance with
             program requirements and, where necessary, their efforts to penalize or sanction
             investors for non-compliance; and

            FHFA’s general oversight of Fannie Mae’s efforts to implement the program, as well
             as its technical expertise and the sufficiency of the resources allocated to these efforts.

With this audit and evaluation strategy, FHFA-OIG believes that it will be well-positioned to:
(1) determine whether FHFA is ensuring that the Enterprises are effectively mitigating REO
risks and costs and the negative impacts of foreclosures on communities; and (2) evaluate the
effectiveness of the controls associated with selling in bulk foreclosed properties with rental
commitments. Further, FHFA-OIG will be in a position to make recommendations, as
necessary, to strengthen the Agency’s REO-related oversight and conservatorship efforts.




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SCOPE AND METHODOLOGY
The objective of this white paper was to provide an overview of the growth in the Enterprises’
REO inventories and their associated risks and costs, FHFA’s oversight of the Enterprises’
management of their REO inventories and risks, and FHFA-OIG’s plans to assess the Agency’s
REO oversight efforts going forward.

To address its objective, FHFA-OIG interviewed senior FHFA officials who were responsible
for monitoring and examining the Enterprises’ management of their REO inventories and
associated risks and costs. FHFA-OIG also interviewed senior FHFA and Fannie Mae officials
who were responsible for the development and implementation of the REO pilot.

FHFA-OIG also reviewed FHFA’s 2012 examinations of the Enterprises’ REO management and
oversight functions as well as examination planning materials. Further, FHFA-OIG reviewed
FHFA financial data on REO management43 and FHFA documents pertaining to the
development of the REO pilot. FHFA-OIG appreciates the cooperation of FHFA and
Fannie Mae management and staff in providing information and access to necessary documents
to accomplish this study.

The preparation of this white paper was conducted under the authority of the Inspector General
Act and is in accordance with the Quality Standards for Inspection and Evaluation (January
2011), which was promulgated by the Council of Inspectors General on Integrity and Efficiency.
These standards require FHFA-OIG to plan and perform evaluations that, among other things,
result in evidence sufficient to provide reasonable bases for its findings and recommendations.
FHFA-OIG believes that the analysis and conclusions contained in this report meet these
standards.

The performance period for this white paper was from March 2012 to May 2012.

FHFA-OIG provided FHFA staff with briefings and presentations concerning the results of its
fieldwork and provided FHFA and the Enterprises with an opportunity to respond to a draft of
this white paper. FHFA and the Enterprises provided technical comments which were
incorporated as appropriate.




43
  FHFA-OIG generally used publicly available data, such as data from the Enterprises’ securities filings, after
determining it was reliable for the purposes of this white paper.


           Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                         32
MAJOR CONTRIBUTORS TO THIS REPORT
Jon Anders

Omolola Anderson

Mendy Breitkopf [Referencer]

Damon Jackson

Timothy Lee

Nicole Mark [Referencer]

Bruce McWilliams

Wesley Phillips

Alan Rhinesmith

David Seide

Simon Wu




        Federal Housing Finance Agency Office of Inspector General • WPR-2012-003 • June 14, 2012
                                                   33
ADDITIONAL INFORMATION AND COPIES


For additional copies of this report:

            Call the Office of Inspector General (OIG) at: 202-730-0880

            Fax your request to: 202-318-0239

            Visit the OIG website at: www.fhfaoig.gov



To report alleged fraud, waste, abuse, mismanagement, or any other kind of criminal or
noncriminal misconduct relative to FHFA’s programs or operations:

            Call our Hotline at: 1-800-793-7724

            Fax your complaint directly to: 202-318-0239

            E-mail us at: oighotline@fhfaoig.gov

            Write to us at: FHFA Office of Inspector General
                             Attn: Office of Investigation – Hotline
                             400 7th Street, SW
                             Washington, DC 20024




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