oversight

The Continued Profitability of Fannie Mae and Freddie Mac Is Not Assured

Published by the Federal Housing Finance Agency, Office of Inspector General on 2015-03-18.

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

 




               Federal Housing Finance Agency 
                   Office of Inspector General




        The Continued Profitability of
        Fannie Mae and Freddie Mac
               Is Not Assured




    White Paper Report  WPR-2015-001  March 18, 2015

 
       

                  Executive Summary 
                  Fannie Mae and Freddie Mac (collectively, the Enterprises) returned to
                  profitability in 2012 after successive years of losses. Their improved financial
                  performance is encouraging; however, their continued profitability is not
                  assured. The mortgage industry is complex, cyclical, and sensitive to changes
                  in economic conditions, mortgage rates, house prices, and other factors. The
WPR‐2015‐001      Enterprises have acknowledged in their public disclosures that adverse market
                  and other changes could lead to additional losses and that their financial results
March 18, 2015    are subject to significant variability from period to period.

                  Notwithstanding the Enterprises’ recent positive financial results, they face
                  many challenges. For example:

                        The Enterprises must reduce the size of their retained investment
                         portfolios over the next few years pursuant to the terms of agreements
                         with the U.S. Department of Treasury (Treasury) and additional limits
                         from FHFA. Declines in the size of these portfolios will reduce
                         portfolio earnings over the long term. These portfolios have been the
                         Enterprises’ largest source of earnings in the past.

                        Core earnings from the Enterprises’ business segments—single-family
                         guarantee, multifamily, and investments—comprised only 40% of net
                         income in 2013. Sixty percent of the Enterprises’ net income came
                         from non-recurring tax-related items and large settlements of legal
                         actions and business disputes, which are not sustainable sources of
                         revenue. Core earnings comprised 55% of net income in 2014.

                        The Enterprises are unable to accumulate a financial cushion to absorb
                         future losses. Pursuant to the terms of agreements with Treasury, the
                         Enterprises are required to pay Treasury each quarter a dividend equal
                         to the excess of their net worth over an applicable capital reserve
                         amount. The applicable capital reserve amount decreases to zero by
                         January 1, 2018.

                        Stress test results released by the Federal Housing Finance Agency
                         (FHFA) in April 2014 indicate that the Enterprises, under the worst
                         scenario—a scenario generally akin to the recent financial crisis—
                         would require additional Treasury draws of either $84.4 billion or $190
                         billion, depending on the treatment of deferred tax assets, through the
                         end of the stress test period, which is the fourth quarter of 2015.

                        Absent Congressional action, or a change in FHFA’s current strategy,
                         the conservatorships will go on indefinitely. The Enterprises’ future
       
       
                                                                 status is beyond their control. At present, it appears that Congressional
                                                                 action will be needed to define what role, if any, the Enterprises play in
                                                                 the housing finance system.

                                                  Fannie Mae reports that it expects to remain profitable for the foreseeable
                                                  future; however, it acknowledges that a decrease in home prices or changes in
                                                  interest rates, combined with provisions of their agreements with Treasury that
                                                  require the reduction of their retained asset portfolios, could lead to losses.1
WPR‐2015‐001                                      Thus, if these losses result in an Enterprise reporting a negative net worth, that
                                                  Enterprise would be obligated to draw on Treasury’s funding commitment.
March 18, 2015 
                                                  FHFA Office of Inspector General (OIG) prepared this white paper to explain
                                                  the many challenges faced by the Enterprises that affect their profitability and
                                                  to caution that the future profitability of the Enterprises is not assured. OIG
                                                  cannot predict whether there is a reasonable possibility that these challenges
                                                  and market conditions will adversely affect the Enterprises in the near future
                                                  and result in losses and further draws on the Treasury.

                                                  This report was produced by Bruce McWilliams, Senior Investigative
                                                  Evaluator; Jon Anders, Program Analyst; Jacob Kennedy, Investigative
                                                  Evaluator; and Desiree I-Ping Yang, Financial Analyst. We appreciate the
                                                  assistance of the officials from FHFA and the Enterprises in completing this
                                                  report.

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




                                                  Kyle D. Roberts
                                                  Acting Deputy Inspector General for Evaluations

       




                                                                  
                                                  1
                                                   See Fannie Mae, 2014 Form 10-K, at 43-47 (Feb. 20, 2015). Freddie Mac does not
                                                  make a similar statement about anticipated profitability in its public disclosures.
       
 


TABLE OF CONTENTS ................................................................  
EXECUTIVE SUMMARY .............................................................................................................2 

ABBREVIATIONS .........................................................................................................................5 

BACKGROUND .............................................................................................................................6 

THE ENTERPRISES’ SOURCES OF EARNINGS .......................................................................7 
      Earnings from Non-Recurring Events ......................................................................................8 
             Guarantee Fees ..................................................................................................................8 
             Net Interest Income from the Retained Portfolio............................................................10 
      Changes in Rates and Other Factors that Result in Changes to the Fair Value of the
      Derivatives Portfolio ...............................................................................................................11 

MARKET FACTORS AND CONDITIONS THAT CAN IMPACT THE
SUSTAINABILITY OF FUTURE EARNINGS ...........................................................................12 
      30-year Mortgage Rates and Volatility...................................................................................13 
      Home Prices ............................................................................................................................14 
      Credit Standards......................................................................................................................15 
      Future Demand for MBS ........................................................................................................16 

ADDITIONAL LAYERS OF UNCERTAINTY CLOUD THE ENTERPRISES’
FUTURE PROFITABILITY .........................................................................................................18 
      Market Conditions ..................................................................................................................18 
      Congressional Action..............................................................................................................18 
      Other Factors ..........................................................................................................................18 
      Dodd-Frank Stress Tests .........................................................................................................19 

CONCLUSION ..............................................................................................................................21 

OBJECTIVE, SCOPE, AND METHODOLOGY .........................................................................22 

ADDITIONAL INFORMATION AND COPIES .........................................................................23 
                                            




 
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ABBREVIATIONS .......................................................................  

Dodd-Frank Act     Dodd-Frank Wall Street Reform and Consumer Protection Act

Enterprises        Fannie Mae and Freddie Mac, collectively

Fannie Mae         Federal National Mortgage Association

FHA                Federal Housing Administration

FHFA               Federal Housing Finance Agency

FOMC               Federal Open Market Committee

Freddie Mac        Federal Home Loan Mortgage Corporation

MBS                Mortgage-Backed Securities

OIG                Federal Housing Finance Agency Office of Inspector General

PSPA               Senior Preferred Stock Purchase Agreement

Treasury           U.S. Department of Treasury




 
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BACKGROUND ..........................................................................  

The FHFA placed the Enterprises in conservatorship in 2008. Catastrophic losses had
depleted the Enterprises’ capital and threatened their ability to provide liquidity to the
secondary mortgage market. Between 2008 and 2011, the Enterprises incurred combined
losses exceeding $200 billion, and have required $187.5 billion in financial support from the
Treasury in order to avert insolvency and receivership. The Enterprises continue to operate in
conservatorship under the direction of FHFA, as conservator.

The Enterprises’ conditions have stabilized and market conditions have improved since 2008.
They returned to profitability in 2012; however, the level of earnings they experienced in
2013 and 2014 is not sustainable over the long term.2 Their 2013 financial results reflected
a significant spike in income due to the release of deferred tax asset valuation allowances.3
Their 2013 and 2014 financial results also included settlements of representation and warranty
claims and non-agency mortgage related securities litigation, but the Enterprises do not expect
settlements to have a significant effect on their financial results in the future.4 Going forward,
the Enterprises will have to rely on their guarantee fee business segments and mortgage-
related investment portfolios for earnings, and those sources are subject to uncertainty.

The Enterprises’ financial results are subject to uncertainty due to changes in the fair value
of their derivatives portfolios. Both Enterprises use derivative instruments, such as interest
rate swaps, as an integral part of their strategy to manage interest rate risk.5 Derivative
instruments are recorded at fair value and marked-to-market to reflect changes in the value
of these instruments due to changes in, for example, short-term and long-term swap rates.
The Enterprises report changes in value of their derivatives portfolios as fair value gains or
losses, and those changes impact financial performance. For example, Fannie Mae reported
fair value gains on derivatives of $3.3 billion in 2013, and fair value derivative losses of
$5.8 billion in 2014, a swing of more than $9 billion.

At the time they were placed in conservatorship, the Enterprises executed Senior Preferred
Stock Purchase Agreements (PSPAs) with Treasury under which Treasury agreed to provide
financial support to them during their conservatorships. As explained in greater detail below,
the PSPAs require the Enterprises to wind down their largest source of earnings—their
                                                            
2
 See Fannie Mae, 2014 Form 10-K, at 11 (Feb. 20, 2015); Freddie Mac, 2014 Form 10-K, at 1-2 (Feb. 19,
2015).
3
    Id.
4
    Id.
5
    See, e.g., Fannie Mae, 2014 Form 10-K, at 3 and 79-80 (Feb. 20, 2015).


 
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respective investment portfolios—to $250 billion by 2018. The mandatory reduction in the
size of the investment portfolios will reduce earnings from these portfolios in the future.6

The PSPAs also prevent the Enterprises from accumulating a financial cushion against future
losses.7 The Enterprises are required to pay Treasury a quarterly dividend equal to the excess
of their net worth over an applicable capital reserve amount. The capital reserve amount is
$1.8 billion for each quarter of 2015 and it decreases by $600 million annually until reaching
zero in 2018. Thus, by 2018, the Enterprises will pay all of their quarterly net worth to
Treasury as a dividend.


THE ENTERPRISES’ SOURCES OF EARNINGS ..............................  

The Enterprises’ income is                                                    FIGURE 1.  THE ENTERPRISES’ ANNUAL NET INCOME (LOSS) 
generated by their single-family,                                                                  (2006‐2014) 
multifamily, and portfolio                                                  150
investment business segments.                                                             Fannie Mae
After successive years of                                                   100
                                                                                          Freddie Mac
incurring heavy losses from                                                  50
                                                               $ Billions




2008-2011, the Enterprises
returned to profitability in                                                   0
2012 (see Figure 1). In 2013,                                                ‐50
they reported record profits of
$132.6 billion in net income;                                               ‐100
this was followed by lesser—                                                ‐150
but still heightened—profits of                                                    2006 2007 2008 2009 2010 2011 2012 2013 2014
$21.9 billion in 2014.
                                                                              Source: FHFA, 2013 Report to Congress, at 73 and 90 (June 13, 2014)
                                                                              (online at www.fhfa.gov/AboutUs/Reports/Pages/Annual-Report-to-
The Enterprises benefitted from                                               Congress-2013.aspx. Fannie Mae, 2014 Form 10-K, at 74 (Feb. 20,
improvements in the housing                                                   2015) and Freddie Mac, 2014 Form 10-K, at 54 (Feb. 19, 2015).
market and declines in their
delinquent loans. During these two years, the Enterprises’ profitability was significantly
generated by non-recurring sources, events that they do not expect to occur again in the
future; specifically, the release of valuation allowances against deferred tax assets, settlements

                                                            
6
 See Fannie Mae, 2014 Form 10-K, at 11-12 (Feb. 20, 2015); and Freddie Mac, 2014 Form 10-K, at 31 (Feb.
19, 2015).
7
 For more information describing the PSPAs, see OIG, Analysis of the 2012 Amendments to the Senior
Preferred Stock Purchase Agreements (Mar. 20, 2013) (WPR-2013-002) (online at
www.fhfaoig.gov/Content/Files/WPR-2013-002_2.pdf).

 
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of disputed representation and warranty claims, and settlements of legal claims relating to
non-agency mortgage-backed securities.

Earnings from Non‐Recurring Events 

To meaningfully discuss the                  FIGURE 2.  THE ENTERPRISES’ CORE EARNINGS AND  
sustainability of future earnings by                NON‐RECURRING ITEMS (2012‐2014) 
the Enterprises, OIG separated non-
recurring events out of the income           $140
from the single-family, multifamily,         $120                             $79 
and portfolio investment business


                                                                     $ Billions
                                             $100
segments. Analyzing the earnings
                                              $80
reported by the Enterprises in 2012,
                                              $60
OIG found that non-recurring
                                              $40                             $53 
earnings contributed $1 billion—                             $1 
                                                                                                $10 
3.6%—of the $28 billion in net                $20           $27 
income. OIG found that, for 2013,              $0                                               $12 
non-recurring events accounted for                         2012              2013              2014
$79 billion—60%—of the $132.6                              Core Earnings        Non‐recurring Items
billion in net income. Results for
2014 reflect that non-recurring          Source: OIG analysis of information contained in the Enterprises’
                                         Annual Report filings with the Securities and Exchange Commission
sources comprise 45% of net
                                         on Form 10-K.
income. Figure 2 illustrates that
non-recurring sources contributed significantly to the Enterprises’ financial performance in
2013 and 2014.

Earnings from Business Segments 

Because future profitability of the Enterprises will be driven significantly by income from
their business segments, we now discuss the elements of the income generated from these
segments. For purposes of this discussion, we label such income as “core earnings” to
distinguish it from income from non-recurring events.

              Guarantee Fees 

Guarantee fees are the primary source of revenue for the Enterprises’ single-family guarantee
business segment.8 The Enterprises receive guarantee fees in exchange for their agreement to
                                                            
8
 The Enterprises use different terms in their financial statements and other materials when referring to this fee.
Fannie Mae uses the term “guaranty fee,” and Freddie Mac uses the term “management and guarantee fee.”
This report adopts FHFA’s convention and uses the term “guarantee fees.”


 
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guarantee the timely payment of principle and interest to investors that purchase their
mortgage-backed securities (MBS). The guarantee fee covers projected credit losses from
borrower defaults over the life of the loans, administrative costs, and a return on capital.9
To calculate the guarantee fee, the Enterprises use proprietary costing models to estimate
expected credit losses based on selected loan attributes (such as borrower credit score and
loan-to-value ratio) and to estimate required capital based on a desired rate of return.10

Legislation from Congress and directives by FHFA, as the Enterprises’ conservator, have
raised the Enterprises’ guarantee fees. In 2012, the Enterprises increased guarantee fees by
20 basis points (or 30% of the guarantee fee level at that time) in response to legislation and
conservator requirements,11 not solely as a result of higher expected credit losses. As policy
perspectives change, the Enterprises’ fees could be reduced in the future. The Federal
Housing Administration’s recent 50 basis point reduction of its annual insurance premiums
is an example of a guarantee fee being reduced to meet public policy objectives.12 FHFA
requested public input on guarantee fee pricing in June 2014 and continues to evaluate further
price changes.13


                                                            
9
 See FHFA, Fannie Mae and Freddie Mac Single-Family Guarantee Fees in 2010 and 2011, at 4 (Revised
Sep. 28, 2012) (online at www.fhfa.gov/AboutUs/Reports/Pages/Fannie-Mae-and-Freddie-Mac-Single-Family-
Guarantee-Fees-in-2010-and-2011-Report.aspx), and FHFA, Fannie Mae and Freddie Mac Single-Family
Guarantee Fees in 2012, at 14-15 (Dec. 2013) (online at www.fhfa.gov/AboutUs/Reports/Pages/Fannie-Mae-
and-Freddie-Mac-Single-Family-Guarantee-Fees-in-2012.aspx).
10
  FHFA, Fannie Mae and Freddie Mac Single-Family Guarantee Fees in 2010 and 2011, at 4-5 (Revised Sep.
28, 2012) (online at www.fhfa.gov/AboutUs/Reports/Pages/Fannie-Mae-and-Freddie-Mac-Single-Family-
Guarantee-Fees-in-2010-and-2011-Report.aspx).
11
   The Temporary Payroll Tax Cut Continuation Act of 2011, Pub. L. 112-78, directed FHFA to increase
guarantee fees charged by the Enterprises by 10 basis points from the average guarantee fees charged in 2011.
See the Act at section 401, as codified in 12 U.S.C. 4547(b)(1)(B). The fees collected from the increase are
remitted directly to the U.S. Treasury. Id. § 4547(b)(3). The 10 basis point increase went into effect on April
1, 2012, and will continue until October 1, 2021. Id. § 4547(f).
FHFA instituted a second 10 basis point guarantee fee increase in 2012 to support its strategic goals for the
Enterprises of encouraging greater participation in the mortgage market by private firms. The increase was
targeted at making guarantee fees paid by larger and smaller lenders more uniform and reducing cross
subsidization between higher-risk and lower-risk mortgages. See FHFA, FHFA Announces Increase in
Guarantee Fees (Aug. 31, 2012) (online at www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Announces-
Increase-in-Guarantee-Fees.aspx).
12
   The Federal Housing Administration (FHA) provides mortgage insurance on loans made by FHA-approved
lenders. We illustrate for purposes of this discussion that guarantee fees are susceptible to policy-related
pressures. See FHA, FHA to Reduce Annual Insurance Premiums (Jan. 8, 2015) (online at
http://portal.hud.gov/hudportal/HUD?src=/press/press_releases_media_advisories/2015/HUDNo_15-001).
13
  See FHFA, FHFA Seeks Input on Fannie Mae and Freddie Mac Guarantee Fees (June 5, 2014) (online at
www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Seeks-Input-on-Fannie-Mae-and-Freddie-Mac-Guarantee-
Fees.aspx), and U.S. House of Representatives Committee on Financial Services, Statement of Melvin L. Watt,


 
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Figure 3 illustrates movements in
                                                                             FIGURE 3.  FANNIE MAE’S AVERAGE ANNUAL GUARANTEE 
the level of Fannie Mae’s guarantee
                                                                                                FEES (2000‐2014) 
fees from 2000 to 2014.14
                                                                                  65
              Net Interest Income from                                            55




                                                                   Basis Points
              the Retained Portfolio                                              45
                                                                                  35
Historically, net interest income
                                           25
from the Enterprises’ retained
portfolios has been their primary          15
source of revenue (see Figure 4).15
Net interest income is the
                                                            Effective G‐fee Rate
difference, or spread, between the
                                                            G‐Fee Rate on New Acquisitions
interest income earned on the
assets in the retained portfolio and     Source: Fannie Mae’s Annual Reports filed with the Securities
the interest expense associated with     and Exchange Commission on Form10-K.
the debt that funds those assets. The
Enterprises’ retained portfolios grew over 700% between 1992 and 2008, and net interest
income became the largest source of earnings. The Enterprises’ combined retained portfolios
were $192 billion as of the end of 1992, and grew to $1.6 trillion as of 2008.

 




                                                            
Director, Federal Housing Finance Agency, at 14 (Jan. 27, 2015) (online at
http://financialservices.house.gov/UploadedFiles/HHRG-114-BA00-WState-MWatt-20150127.pdf).
14
   For the years 2000-2007, Fannie Mae’s effective guarantee fee rate shown is guarantee fee income as a
percentage of average outstanding MBS and other guarantees. For 2008-2014, the effective guarantee fee rate
is calculated based on single-family guarantee fee income divided by the average single-family guarantee book
of business. The guarantee fee rate charged on new acquisitions is a calculation of the average contractual fee
rate for new acquisitions during each year plus the recognition of any up-front cash payments over the
estimated average life of the acquisitions. See Fannie Mae, 2007 Form 10-K, at 47 (Feb. 27, 2008) and Fannie
Mae, 2014 Form 10-K, at 87 (Feb. 20, 2015).
15
   With the adoption of accounting guidance related to transfers of financial assets and consolidation of
variable interest entities, effective January 1, 2010, guarantee fee income associated with the securitization
activities of consolidated trusts is reflected in net interest income and no longer reported separately. See
Fannie Mae, 2010 Form 10-K, at 82 (Feb. 24, 2011); Freddie Mac, 2010 Form 10-K, at 193 (Feb. 24, 2011).

 
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While in conservatorship,            FIGURE 4.  THE ENTERPRISES’ COMBINED GUARANTEE FEE AND  
the Enterprises are required                          NET INTEREST INCOME (2000‐2014) 
to reduce the size of their
retained portfolios in
accordance with a
designated schedule,
and these mandatory
reductions will reduce
earnings from these
portfolios in the future.
The PSPAs require the
Enterprises to reduce the
size of their retained
portfolios by 15% per
year until they reach $250
billion by 2018.16 Since
the conservatorships            Source: OIG analysis of information contained in the Enterprises’ Annual
                                Report filings with the Securities and Exchange Commission on Form 10-K.
began in 2008, the size
of the Enterprises’ retained portfolios has declined dramatically. Fannie Mae’s total mortgage
related investment portfolio was $413.3 billion as of December 31, 2014; Freddie Mac’s
comparable portfolio was $408.4 billion. The Enterprises have cautioned that any income
growth from guarantee fees may not completely offset the loss in income from the retained
portfolios.

Changes in Rates and Other Factors that Result in Changes to the Fair Value of the 
Derivatives Portfolio 

The Enterprises, like many financial institutions, use derivatives to hedge against various risks,
such as fluctuating interest rates. They use a variety of derivative instruments, including interest
rate swaps, as an integral part of their interest rate risk management strategies. Derivative
instruments are recorded at fair value and marked-to-market in the Enterprises’ financial
statements to reflect changes in the value of these instruments due to changes in, for example,
short-term and long-term swap rates.17 The Enterprises report changes in the value of their
derivatives portfolios as fair value gains or losses, and the impact of those changes affects
financial performance. For example, Fannie Mae reported fair value gains on derivatives of


                                                            
16
  See OIG, Analysis of the 2012 Amendments to the Senior Preferred Stock Purchase Agreements, at 12 (Mar.
20, 2013) (WPR-2013-002) (online at http://fhfaoig.gov/Content/Files/WPR-2013-002_2.pdf).
17
  The fair value of derivatives is also sensitive to changes, for example, in interest rates, yield curves, implied
volatility, and mortgage spreads.

 
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$3.3 billion in 2013, and fair value losses of $5.8 billion in 2014, a swing of more than
$9 billion.

Under the PSPAs, losses from derivatives could require a draw if they cause an Enterprise’s
liabilities to exceed the assets on its balance sheet and the Enterprise’s losses exceed the
applicable capital reserve amount. Stated differently, if derivatives losses, expenses, and
other adjustments exceed revenues and applicable capital reserve amount, a draw from
Treasury would be required to cover the negative net worth amount.


MARKET FACTORS AND CONDITIONS THAT CAN IMPACT 
THE SUSTAINABILITY OF FUTURE EARNINGS .............................  

As we have explained, there is significant uncertainty concerning the future performance of
the Enterprises’ business segments. This uncertainty is attributable to:
       The winding down of their investment portfolios and loss of interest income;

       The level of guarantee fees they will be able to charge;

       The elimination of a capital cushion to buffer losses;

       The changes in rates that can cause fair value losses or fair value gains on the
        Enterprises’ derivatives portfolios; and

       The elimination of non-recurring events will affect the profitability of the Enterprises.

There are a number of other factors, which we now discuss, that can also affect Enterprise
profitability.

The housing finance industry is inherently sensitive to fluctuations in key economic variables,
such as interest rates, home prices, and unemployment levels. Such drivers generally follow
cyclical patterns that can lead to boom and bust periods in the industry and affect the volume
of mortgage prepayments and new mortgage originations. Further, the credit standards
applied by lenders to the mortgages they originate expand and contract, impacting both the
volume of new originations and the potential losses for mortgage creditors and guarantors,
such as the Enterprises. Trends in prepayments and mortgage originations have a direct
influence on their income.




 
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30‐year Mortgage Rates and Volatility

As shown in Figure 5,               FIGURE 5.  MORTGAGE ORIGINATIONS AND THE THIRTY‐YEAR 
interest rates for 30-year                           MORTGAGE RATE (2000‐2014) 
fixed-rate mortgages, the
                                    $1,200                                                           9




                                                               Origination Volume ($Billions)
most commonly available
                                    $1,000                                                           8
mortgage in the United




                                                                                                          Interest Rate
States, are subject to               $800                                                            7
volatility. Mortgage rate            $600                                                            6
volatility occurs because            $400                                                            5
of many factors relating
                                     $200                                                            4
to housing finance and the
                                         $0                                                          3
broader U.S. economy,
including the investor
demand for MBS, the
monetary policy of the                                      Mortgage Purchases
Board of Governors of the                                   Mortgage Refinances
Federal Reserve System                                      30‐Year Mortgage Rate
and the Federal Open
Market Committee (FOMC),          Source: Mortgage Bankers Association, Quarterly Origination Estimates
                                  (Feb. 2015) and Freddie Mac Primary Mortgage Market Survey (online at
and the general demand for        www.freddiemac.com/pmms/).
credit in the United States.
Volatility in mortgage rates can have a significant impact on the level of mortgage
prepayments and new originations. Generally speaking, falling interest rates provide
incentive to borrowers to purchase new homes or refinance existing mortgages.18 Figure 5
illustrates that when mortgage interest rates fell by over three hundred basis points between
2000 and 2003, the mortgage industry originated record high volumes of new mortgages.

Conversely, mortgage origination volumes in a rising rate environment typically decline. As
rates currently hover near historical lows, it is likely that their future trajectory will trend
upwards. Freddie Mac forecasts that mortgage interest rates will climb to 5.1% by the end of
2016. It predicts $1.275 trillion in mortgage originations that year, a decline of almost $850
billion from 2012 levels.19



                                                            
18
  See Daniel K. Tarullo, Governor, Fed. Reserve Board, Unemployment, the Labor Market, and the Economy,
Speech at the World Leaders Forum, Columbia University, New York, New York (Oct. 20, 2011) (online at
www.federalreserve.gov/newsevents/speech/tarullo20111020a.htm).
19
  See Freddie Mac, Office of the Chief Economist, February 2015 U.S. Economic & Housing Market Outlook
(Feb. 17, 2015) (online at www.freddiemac.com/finance/pdf/february_2015_public_outlook.pdf).

 
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Home Prices 

Home prices fluctuate depending on
                                                                                   FIGURE 6.  STANDARD & POORS/CASE‐SHILLER  
key drivers, such as mortgage                                                      U.S. NATIONAL HOME PRICE INDEX (2000‐2014) 
interest rates, employment
levels, and household                                                        190
formation. Between 2001 and                                                  180
2005, home prices grew by an                                                 170
                                                                             160



                                                               Index Level
annual rate of 10.6% before
                                                                             150
peaking in 2006 and then
                                                                             140
dropping precipitously (see                                                  130
Figure 6). As a result of a                                                  120
combination of factors, national                                             110
home values fell by 27%                                                      100
between July 2006 and
February 2012.20 After large
price gains since 2012, Freddie                                              Source: S&P Dow Jones Indices (online at
Mac predicts slowed growth in                                                http://us.spindices.com/indices/real-estate/sp-case-shiller-us-
                                                                             national-home-price-index).
prices over the next two years.21

Home prices and mortgage interest rates influence borrower behavior and trends in
origination volumes and composition, such as refinance activity or purchase money
mortgages. For example, refinance activity falls relative to purchase money mortgages in a
rising interest rate environment, and total origination activity falls as well.22 Reduced demand
for mortgages results in lower origination volumes. Origination activity in 2014 was




                                                            
20
   Home price declines were far greater in certain markets. For example, the Urban Institute, using CoreLogic
data, calculated that house prices fell over 53% from peak-to-trough in the Riverside, California metropolitan
area. See Urban Institute, Housing Finance At A Glance: A Monthly Chartbook, at 17 (Jan. 2015) (online at
www.urban.org/publications/2000075.html).
21
  Freddie Mac forecasts a 3.9% annual increases in U.S. home prices in 2015 and a 3.4% increase in 2016.
See Freddie Mac, Office of the Chief Economist, February 2015 U.S. Economic & Housing Market Outlook
(Feb. 17, 2015) (online at www.freddiemac.com/finance/pdf/february_2015_public_outlook.pdf).
22
  The Mortgage Bankers Association forecasts that the share of refinance originations will fall to 32% in
2016, down from 60% in 2013. Freddie Mac predicts that refinance originations will make up 30% of all
mortgages in 2016. Refinances made up the majority of mortgage originations between 2000 and 2013. See
Mortgage Bankers Association, Mortgage Finance Forecast (Dec. 15, 2014) and Freddie Mac, Office of the
Chief Economist, February 2015 U.S. Economic & Housing Market Outlook (Feb. 17, 2015) (online at
www.freddiemac.com/finance/pdf/february_2015_public_outlook.pdf).


 
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significantly lower than 2013; however, Freddie Mac and the Mortgage Bankers Association
forecast higher purchase mortgage volumes in 2015 and 2016.23

Home prices also have an effect on the Enterprises’ loss severity when borrowers default on
their mortgages. High foreclosure rates result in large inventories of real estate owned, also
known as foreclosed properties. When the Enterprises sell real estate owned in depressed
housing markets, they receive lower prices on those properties. Correspondingly, their loss
severities increase and they incur higher credit losses.

Credit Standards 

Historically, credit standards tend to tighten or loosen depending on market conditions,
perceptions of risk, and policy pressures. Following the boom in refinances in 2000-2003,
lenders expanded their use of nontraditional mortgage products (e.g., subprime, Alt-A, low
doc/no doc, stated income, payment option). Credit discipline eroded and market participants
adopted reckless practices.24 Relaxed underwriting standards were a contributing factor to the
collapse of the housing finance system. Figure 7 below illustrates the cumulative default rates
of Fannie Mae single-family mortgage loans by origination year. The higher default rates on
loans originated between 2005 and 2007 reflect the impact of loosened credit standards.




                                                            
23
  See Freddie Mac, Office of the Chief Economist, December 2014 Economic and Housing Market Outlook
(Dec. 15, 2014) (online at www.freddiemac.com/finance/pdf/December_2014_public_outlook.pdf) and
Mortgage Bankers Association, Mortgage Finance Forecast (Dec. 15, 2014).
24
  See generally, the Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Commission Report
“Chapter 7: The Mortgage Machine” (Jan. 2011) (online at http://fcic.law.stanford.edu/report).

 
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           FIGURE 7.  CUMULATIVE DEFAULT RATES OF FANNIE MAE’S SINGLE‐FAMILY CONVENTIONAL  
               GUARANTEE BOOK OF BUSINESS BY YEAR OF ORIGINATION (AS OF DEC. 31, 2011)  




Source: Fannie Mae, 2011 Credit Supplement, at 15 (Feb. 29, 2012) (online at
www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2011/q42011_credit_summary.pdf).

Since 2007, mortgage lenders have significantly tightened their credit standards in response
to many factors, including credit losses; new regulation, such as the Consumer Financial
Protection Bureau’s Ability to Repay Rule;25 and the risk of repurchase requests by the
Enterprises for loans sold to them that did not comply with their standards.

Future Demand for MBS 

In October 2014, the FOMC announced that it had ended its asset purchase program,26 but
would continue its policy of replenishing its MBS portfolio by reinvesting principal payments
from its existing holdings.27 It is uncertain when the FOMC will cease investing in MBS.
The Mortgage Bankers Association suggests that the Federal Reserve, which has been the
single largest purchaser of MBS over the past few years, will likely exit the MBS market in

                                                            
25
  See Consumer Financial Protection Bureau, Ability-to-Repay and Qualified Mortgage Standards Under the
Truth in Lending Act (Regulation Z), 78 Fed. Reg. 35429 (June 12, 2013) (final rule).
26
  The Open Market Trading Desk at the Federal Reserve Bank of New York implements monetary policy on
behalf of the FOMC through domestic market operations, such as the now-terminated asset purchase program.
For more information, see Federal Reserve Bank of New York, Domestic Market Operations (online at
www.newyorkfed.org/markets/openmarket.html).
27
  See Board of Governors of the Federal Reserve System, Federal Reserve Issues FOMC Statement (Oct. 29,
2014) (online at www.federalreserve.gov/newsevents/press/monetary/20141029a.htm).


 
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mid-2015.28 The ramifications of the FOMC’s decision to end the asset purchase program
will not be clear until the market adjusts to the changed environment. Figure 8 illustrates the
holdings of MBS and mortgage debt among investor type between 1985 and 2014.

                                       FIGURE 8.  HOLDERS OF AGENCY MBS AND DEBT (1985‐2014)   




Source: Federal Reserve data as analyzed by the Mortgage Bankers Association. See Mortgage Bankers
Association, Who Will Own Mortgage Assets? (Nov. 2014) (online at
http://mba.informz.net/MBA/data/images/112014_Mortgage_Assets_White_Paper.pdf).

There is no obvious single player prepared to take over the Federal Reserve’s position as
the dominant purchaser. Investors in MBS have different incentives for holding these
instruments, and their investment strategies are influenced by a variety of factors, including
regulatory capital and liquidity standards (e.g., Basel III and liquidity requirements); risk
appetite and return objectives; and access to funding at favorable rates. The Mortgage
Bankers Association estimates modest gains in demand for MBS issuance in 2015 and expects
total mortgage production to remain low. This lack of production combined with factors
beyond FHFA and the Enterprises’ control create uncertainty about the future source of
capital to fund the housing mortgage market and who the holders will be of MBS.


                                                            
28
   See Michael Fratantoni, Mortgage Bankers Association, Who Will Own Mortgage Assets?, at 3 (Nov. 2014)
(online at http://mba.informz.net/MBA/data/images/112014_Mortgage_Assets_White_Paper.pdf). The
Mortgage Bankers Association predicts that the Federal Reserve will likely cease investing in MBS after the
first increase in its target short-term interest rate, which the Mortgage Bankers Association anticipates will
likely occur in mid-2015.

 
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ADDITIONAL LAYERS OF UNCERTAINTY CLOUD THE 
ENTERPRISES’ FUTURE PROFITABILITY ......................................  

Market Conditions 

The housing finance system is in the midst of a period of significant uncertainty, and those
uncertainties will have an impact on key market drivers such as home mortgage rates, homes
prices, credit standards, and other rates (e.g., short-term and long-term swap rates) that impact
the Enterprises’ financial performance. Future profitability will be determined by how these
drivers change and to what degree. The recent housing and economic crisis is proof that
certain combinations of these drivers—for example, abrupt, significant, and prolonged drops
in home prices, high unemployment, and unexpectedly high mortgage defaults29—will result
in substantial losses at the Enterprises. Whether those drivers converge again in the same
manner with the same result is unknown.

Congressional Action 

Congress and the administration appear to agree that the current housing finance system is not
viable and that legislation is needed to address fundamental industry issues. At present, there
is no indication that the final resolution of these issues will occur in the near term. FHFA’s
current expectation is that the conservatorships will continue until legislation is passed and the
Enterprises’ future is settled.

Other Factors 

While it is known that market conditions and the uncertainty of the Enterprises’ status will
affect future profitability, the next specific source of instability in the Enterprises’ financial
performance is not known. OIG is currently reviewing a number of issues that may lead to
financial losses at the Enterprises. In particular, we will release a white paper surveying the
risk posed to the Enterprises by cyber-attacks,30 and we continue to evaluate the risk of losses




                                                            
29
   While the number of the Enterprises’ seriously delinquent mortgages—those loans that are 90 days or more
past due or in the foreclosure process—has declined in recent years, they remain elevated compared to pre-
crisis levels.
30
   The Enterprises maintain protected personal information about mortgage borrowers as well as sensitive
financial data related to their capital markets operations. The compromise of such data through infiltration
could lead to potential loss exposure for the Enterprises.


 
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to the Enterprises resulting from the failure of counterparties to meet their contractual
obligations.31

Dodd‐Frank Stress Tests 

In 2014, FHFA reported on the                                           FIGURE 9.  PROJECTED ENTERPRISE DIVIDENDS AND DRAWS 
results of the Enterprises’ series of                                      UNDER THE FHFA AND DODD‐FRANK ACT STRESS TEST 
stress tests conducted in accordance                                                 SCENARIOS (Q4 2013‐Q4 2015) 
with the Dodd-Frank Wall Street                                                $100
Reform and Consumer Protection                                                          54       52
                                                                                $50                       36
Act (the Dodd-Frank Act)32 and
FHFA’s instructions and stress                                                   $0
                                                                  $ Billions
scenarios. The results varied                                                   ‐$50
considerably among the different
                                                                               ‐$100      Dividend Payments        ‐84
stress scenarios, as shown in
                                                                               ‐$150      Treasury Draws
Figure 9.
                                                                               ‐$200
Under the Dodd-Frank Act                                                                                                     ‐190
                                                                               ‐$250
severely adverse scenario, which
                                                                                       FHFA 1   FHFA 2   FHFA 3    Dodd‐     Dodd‐
simulates conditions generally                                                                                    Frank 1   Frank 2
comparable to the recent financial                                Source: FHFA, Projections of the Enterprises’ Financial
crisis, the Enterprises project that                              Performance (Stress Tests), at 3 (Apr. 30, 2014) (online at
they will require combined draws                                  www.fhfa.gov/AboutUs/Reports/Pages/Projections%20of%20the%2
                                                                  0Enterprises-Financial-Performance-April-30-2014.aspx).
of $84 billion or $190 billion,



                                                            
31
   Fannie Mae’s 2013 Annual Report disclosed that: (1) the Enterprise is acquiring an increasing portion of its
business volume directly from smaller or non-depository financial institutions, which may not have the same
financial strength, liquidity, or operational capacity as its larger depository financial institution counterparties;
and (2) this potentially lower financial strength, liquidity, and operational capacity of nonbank sellers may
negatively affect their ability to satisfy their repurchase or compensatory fee obligations to the Enterprise. The
decrease in the concentration of the Enterprise’s business with large depository financial institutions could
increase both institutional counterparty credit risk and mortgage credit risk, and could have a material, adverse
effect on the Enterprise’s business, results of operations, financial condition, liquidity, and net worth. See
Fannie Mae, 2013 Form 10-K, at 38 (Feb. 21, 2014).
32
   The Dodd-Frank Act, Pub. L. 111-203, requires large federally-regulated companies—those with $10 billion
or more in assets—to conduct annual stress tests to determine whether they have the capital necessary to
absorb losses as a result of adverse economic conditions. 12 U.S.C. § 5365(i)(2). According to FHFA, the
Enterprises are required to submit the results of stress tests based on three scenarios: Baseline, Adverse, and
Severely Adverse. Only the Severely Adverse results are required to be released publicly. FHFA’s scenarios
are intended to be consistent with those provided by the Board of Governors of the Federal Reserve System,
Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency to allow for
comparison with other financial institutions’ stress test results.


 
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depending on whether they created valuation allowances for deferred tax assets.33 Under the
FHFA’s worst case scenario, which is far less severe than the Dodd-Frank Act severely
adverse scenario, no required draws are projected.

                                                            




                                                            
33
  See FHFA, Projections of the Enterprises’ Financial Performance (Stress Tests), at 3 (Apr. 30, 2014)
(online at www.fhfa.gov/AboutUs/Reports/Pages/Projections%20of%20the%20Enterprises-Financial-
Performance-April-30-2014.aspx).

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

Imprudent business practices and unfavorable market conditions led to the Enterprises’
financial collapse and conservatorship in 2008. After years of huge losses, the Enterprises
have reported net income since 2012. Non-recurring events have been a significant driver
of earnings in 2013 and 2014 and are unlikely to drive future earnings. While OIG cannot
predict whether additional Treasury investments to either Enterprise is a reasonable possibility
in the near future, we recognize that significant uncertainties concerning the level of
guarantee fees the Enterprises will be able to charge, when combined with the winding down
of their investment portfolios and loss of interest income, and possible losses on the
derivatives portfolios, mean that the Enterprises’ future profitability is far from assured. The
reduction and eventual elimination of the Enterprises’ capital reserves increases the likelihood
of additional Treasury investment. Changes in market conditions and the uncertainty of the
current mortgage securities market can further affect future profitability, as shown by recent
Dodd-Frank Act stress tests. For all of these reasons, stakeholders should not presume
continued profitability of the Enterprises.

                               




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

The objectives of this white paper were to explain the many challenges faced by the
Enterprises that affect their profitability and to caution that the future profitability of
the Enterprises is not assured. To address this report’s objectives, we interviewed the
Enterprises’ Chief Financial Officers as well as officials responsible for financial reporting
and forecasting. We also interviewed FHFA’s Chief Accountant and officials from the Office
of the Financial Analysis, Modeling and Simulations and the Office of Risk Analysis.

We also reviewed publicly available data from the Enterprises’ filings with the Securities and
Exchange Commission, FHFA’s annual reports to Congress and reports on the Enterprises’
financial performance, the Office of Federal Housing Enterprise Oversight’s reports on
mortgage markets and the Enterprises, and the Board of Governors of the Federal Reserve
System’s statistical data releases. Additionally, we reviewed non-public information provided
by the Enterprises and FHFA. The data used in this report covered the period from 2000
through the end of 2014, when available. We did not independently test the reliability of the
Enterprises’ or FHFA’s data. For comparison purposes, we used “Net Income” as reported by
the Enterprises and then standardized by FHFA, throughout the paper.34

The preparation of this white paper was conducted under the authority of the Inspector
General Act of 1978, and in accordance with The Quality Control Standards for Inspection
and Evaluation (January 2012), which was issued by the Council of the Inspectors General
on Integrity and Efficiency. These standards require OIG to plan and perform evaluations to
obtain evidence sufficient to provide a reasonable basis for its findings and recommendations.
We believe that this white paper meets these standards. The performance period for this
white paper report was from November 2014 to February 2015.

We provided FHFA with the opportunity to respond to a draft of this white paper. We
appreciate the efforts of FHFA, the Enterprises, and their staff in providing information and
access to necessary documents to accomplish this study.




                                                            
34
  Beginning in 2010, the Enterprises began reporting “Comprehensive Income.” Comprehensive Income is
comprised of Net Income and Other Comprehensive Income or Loss, which is defined as the change in equity,
net of tax, resulting from transactions that the Enterprises record directly to stockholders’ equity.

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


For additional copies of this report:

       Call: 202-730-0880

       Fax: 202-318-0239

       Visit: www.fhfaoig.gov



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

       Call: 1-800-793-7724

       Fax: 202-318-0358

       Visit: www.fhfaoig.gov/ReportFraud

       Write:

                 FHFA Office of Inspector General
                 Attn: Office of Investigation – Hotline
                 400 Seventh Street, S.W.
                 Washington, DC 20024




 
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