FHFA-OIG Looks at GSE Counterparty Risk, Servicing Contracts

By: Jann Swanson •

The Federal Housing Finance Agency's Office of Inspector General (FHFA-OIG) has completed two evaluations related to servicing of Fannie Mae and Freddie Mac's (the GSEs) owned and guaranteed portfolios.  Reports were issued on Tuesday from an evaluation related to Fannie Mae's High Touch Servicing Program and a separate evaluation of FHFA's oversight of the GSE's management of high-risk sellers and servicers.  

The first evaluation looked at a program initiated by Fannie Mae to handle high risk loans.  FHFA-OIG evaluated a single transaction between Freddie Mac and Bank of America under its High Touch Servicing Program.  While it found little to fault about that transaction it did suggest a few specific changes in FHFA and Fannie Mae management and supervision.

The High Touch Servicing Program utilizes specialty servicers who work with at-risk borrowers to help reduce the defaults on mortgages owned or guaranteed by Fannie Mae.  In order to transfer mortgage servicing rights (MSR) to those servicers Fannie May must first terminate the current servicing contract.  In the summer of 2011 Fannie Mae proposed to purchase the mortgage servicing rights to approximately 384,000 mortgage loans from Bank of America (BOA) for $512 million, a transaction that attracted the attention of the media and of Congress which asked OIG to review it.

OIG found that the transaction with BOA was part of a larger and essentially sound initiative.  That transaction was the largest for the High Touch Program to that point and the amount paid was consistent with other transactions under the program.   An internal audit by Fannie Mae, however, raised questions about the controls surrounding the servicing program as well as the likelihood it would achieve the projected savings.  Similarly FHFA-OIG found that Fannie Mae had relied on a single consultant to price most transactions under the program and that the terms of the standard  Fannie Mae servicing contract appeared to constrain transfers at no or reduced cost for reasons related to the portfolio's performance.  It also determined that FHFA's oversight of the program needed improvement.

FHFA-OIG recommends that FHFA ensure that Fannie Mae does not have to pay a premium to transfer inadequately performing portfolios.  This might be achieved through the reduction or elimination of the 90 day period during which servicers are able to seek potential buyers for a portfolio, contract provisions allowing purchase of MSR at a pre-established rate based on performance criteria or by Fannie Mae's retention of the right to approve the sale of MSR to ensure transfer to an appropriate servicer.

The report makes several other recommendations:

  • FHFA should henceforth require that Fannie Mae and Freddie Mac (the GSEs) get approval from FHFA for any unusual or high cost new initiatives.
  • FHFA should ensure that Fannie may apply more rigor and scrutiny to pricing significant MSR transactions.
  • FHFA should review the assumptions underlying High Touch and, as the program develops reevaluate the performance criteria.

The second evaluation arose out of the bankruptcy of a Freddie Mac servicer in 2009.  The GSEs monitor counterparties (e.g., sellers and servicers) that they have designated as high-risk and as of the third quarter of 2011 had over 300 servicers on watch lists and had stopped doing business with 40 of them.   When the bankruptcy occurred, Freddie Mac had to file a $1.8 billion claim against the servicer's estate, part of an estimated $6.1 billion the GSEs have lost from failures of four counterparties since 2008.  The GSEs estimate they have a remaining risk exposure of approximately $7.2 billion from counterparty portfolios totaling $955 billion.

The FHFA-OIG evaluation found that FHFA had asked for contingency plans from the GSEs for managing credit and counterparty risk but had not published written policy guidance for these plans, instead field testing draft examinations procedures, hoping that the GSEs would voluntarily conform their procedures to the Agency's examination instructions.  Consequently, the GSEs have not developed plans. 

Fannie Mae initially said its "Action Plans" for high risk seller/servicers were contingency plans but FHFA-OIG noted that, while they listed remedial actions for specific deficiencies, they do not lay out advance comprehensive plans for reducing the GSEs' risk exposure.  In response to a second request for plans, Fannie Mae told FHFA that it had informally discussed such planning without developing an actual plan.

In response to FHFA-OIG's request for plans, Freddie Mac provided various documents for screening counterparties, monitoring them, and remediating specific risks.  While these actions may help mitigate Freddie Mac's counterparty risk, the GSEs' tools and actions do not constitute an overall contingency plan because they do not lay out a comprehensive plan of action in the case of deteriorating financial condition or failure of a counterparty.

In early 2012 the examiners-in-charge of both GSEs agreed with FHFA-OIG's conclusion that the GSE's do not have adequate contingency plans to manage the risk of a failed seller/servicer.  FHFA-OIG recommended that FHFA issue standards for the GSEs to develop comprehensive contingency plans that at a minimum should include quantitative assessment, event management, monitoring, and testing elements and that it finalize its February 2012 draft examination manual to include elements related to contingency planning.