FHFA Criticized for Process Leading to Repurchase Changes

By: Jann Swanson •

The Federal Housing Finance Agency's (FHFA) Office of the Inspector General (OIG) has released an audit critical of the FHFA for decision making leading to changes in the Representation and Warranty Framework for Fannie Mae and Freddie Mac, the government sponsored enterprises (GSEs) under FHFA conservatorship.  Those changes were a component of FHFA's Contract Harmonization Project initiated in June 2011 to improve the GSEs' contracts and contracting processes with its seller servicers. 

As a result of discussions between FHFA and the GSEs the Agency determined that contract harmonization was necessary and appropriate and on January 19, 2012 directed the GSEs to align their contracts in eight areas, two of which were priorities with 180 day deadlines: 1) Consistent and precise benchmarks and measurable standards for repurchase requests and other penalties for non-performance and 2) Consistent timelines and collection standards for fees and penalties.  The first priority initiated the process of changing the GSEs' representation and warranty framework which was implemented on January 1, 2013.

Under the pre-2013 contracts seller representations and warranties generally related to the underwriting of the borrower, the mortgaged premises, and the project within which the property is located.  Where a mortgage was not compliant with Fannie Mae's Selling Guide or Freddie Mac's purchase documents the GSEs could exercise contractual remedies including a request for repurchase. The changes made to the framework were designed to clarify seller repurchase exposure and liability on loans sold to the GSEs with the goal of maximizing the seller-servicers performance and therefore the economic return of the GSEs' loan portfolio.

The announced highlights of the new framework were:

  • Relieving sellers of certain repurchase obligations for loans that met specific payment requirements such as 36 months of consecutive, on-time payments.
  • Making Home Affordable Refinance Program (HARP) loans eligible for representation and warranty relief after an acceptable payment history of only 12 months.
  • Detailing information about exclusions for representation and warranty relief, such as violations of state, federal, and local laws and regulations.
  • Making a range of tolls available to sellers to help improve loan quality.

The new framework also moved the focus of quality control reviews from the time a loan defaults up to the time the loan is delivered to Fannie Mae and Freddie Mac. FHFA also directed the GSEs to:

  • Conduct quality control reviews earlier in the loan process, generally between 30 to 120 days after loan purchase.
  • Establish consistent timelines for sellers to submit requested loan files for review.
  • Evaluate loan files on a more comprehensive basis to ensure a focus on identifying significant deficiencies.
  • Leverage data from the tools currently used by Fannie Mae and Freddie Mac to enable earlier identification of potentially defective loans.
  • Make available more transparent appeals processes for sellers to appeal repurchase requests.

OIG says there is a significant financial magnitude to the GSEs' risk management programs and quality control processes brought about by these changes, especially the change in responsibility for loan underwriting.   In 2013, the first year for the new framework, the GSEs bought approximately 5.6 million loans from sellers with a total unpaid principal balance exceeding $1.13 trillion.  This elevated risk was the reason the FHFA OIG audited FHFA's oversight of the GSEs' implementation of the new framework.

OIG's criticism of FHFA's oversight of the framework changes revolves primarily around the process under which the new framework was designed and implemented.  The Office provides the following background of that process. 

During the design and discussion period leading up to the changes each of the GSEs reviewed the risks involved in the changes.  Freddie Mac did a complete risk analysis finding that while the additional pre- and post-funding assessments could result in better initial quality control sampling and loan reviews, after the repurchase requirement sunsets and credit risk transfers to the company those risks would increase.  Accurate identification of loan sunset eligibility, the representation and warranty holder at any given time, and the sunset date would be critical to monitoring risk and accurately enforcing quality control. 

Freddie Mac also identified where additional resources would be needed in the form of increased staff, updated processes and procedures, and new or enhanced technology and systems. It specifically identified two systems it would need to create in addition to enhancing multiple existing systems and estimated it would take two years for full functionality of the systems. 

Fannie Mae did not prepare a similar risk analysis but it did complete a pre-implementation review of the new framework and issued its findings one day after the new framework became effective.  It identified fifteen individual work streams related to FHFAs directive and communicating the new approach to sellers, developing new analytical tools, refining existing defect definitions and actions for findings, and developing new analytical tools to identify and select a statistically valid sample population.   As of July 2014 Fannie Mae was still in the process of completing implementation of new and enhanced systems to support the framework with full roll-out projected for late 2015. 

Fannie Mae's internal review notably found no formally documented, integrated vision within the company for how the redesigned processes and systems will operate in the future, or how other stakeholders may be affected by the change.  It concluded that the full scope of efforts needed to implement change and manage the associated risks would not be known until management could articulate such a vision and that company-wide impacts and risks would not be mitigated until after the January 1, 2013, effective date for the new framework.

FHFA reviewed the proposals, studies, and risk analyses provided by the GSEs and moved forward with its plans to announce a new framework in September 2012. The sunset period set by FHFA was 36 months of consecutive on-time payments or 60 months if the loan was current on the 60th month, provided there were no more than two 30-day delinquencies in the first 36 months.   OIG noted that FHFA set this sunset period without analyzing whether financial risks were appropriately balanced between the GSEs and the sellers nor did it validate the GSEs' analyses on the subject.  Fannie Mae's supported the suggested 36 months as sufficient to sunset repurchase obligations but Freddie Mac suggested that loans with 48 months of clean payments were significantly less likely to exhibit repurchaseable defects.  OIG says this indicates a longer sunset period could lesson losses and that the FHFA cannot support that its decision does not unduly benefit sellers over the GSEs.

FHFA's Office of Housing and Regulatory Policy (OHRP) explained that FHFA's Acting Director and senior executives were briefed in June 2012 and adopted the 36 month sunset period.  Other key decisions about the "term sheet" required the use of automated underwriting systems or risk assessment, specified appraisal requirements, collateral valuation checks, enhanced performing loan sampling and other quality control measures. 

The final term sheet was adopted September 6, 2012 and included the addition of three loan level eligibility criteria, including a sunset period of 12 months for one Freddie Mac and two Fannie Mae refinance products.  Four days later FHFA directed the GSEs to replace the existing framework with the amended framework and commence implementation.

More than a year later, on May 12, 2014, the GSEs announced a number of significant FHGA directed enhancements to the framework for loans delivered to them after July 1, 2014. These included:

  • Relaxing the acceptable payment history for mortgages (with the exception of certain refinance mortgages) from the previous 60 monthly payments to 36 monthly payments.
  • Adding a path for relief the satisfactory conclusion of a GSE quality control review of the mortgage.
  • Providing sellers with written notices of mortgages that met the eligibility requirements for relief from the selling representations and warranties.
  • Implementing an alternative wherein the seller might "stand in" on a mortgage rather than being required to repurchase should the primary mortgage insurance be rescinded.

Coinciding with these changes FHFA released its 2014 Strategic Plan for the Conservatorships of Fannie Mae and Freddie Mac. FHFA's strategic plan indicated that in an effort to provide greater market certainty, FHFA would evaluate and act, where appropriate, on changes to the framework. Further, the strategic plan stated that lack of clarity about representation and warranty requirements can contribute to decisions by sellers to add credit overlays that can unnecessarily limit access to credit and that greater certainty about both origination and servicing obligations should help increase sellers' willingness to more fully provide credit within the GSEs' underwriting standards.

FHFA is planning future changes to the new framework and is addressing the scope of life of loan exemptions, recognizing lenders' concerns about how these exemptions apply to loans that have passed quality control reviews or have met the 36-month sunset period.   During the next year, FHFA will also explore:

  • Establishing an independent dispute resolution program when lenders believe a repurchase is unwarranted;
  • Developing cure mechanisms for loan defects rather than relying solely on repurchases; and
  • Providing additional clarity on Fannie Mae and Freddie Mac underwriting rules.

OIG also found that despite significant changes to the GSEs' systems and processes, FHFA has done little to ensure that necessary controls are in place and operating effectively prior to sunset. The GSEs need to shift primary quality control efforts from nonperforming loans where underwriting defects may be more obvious to the larger population of performing loans within the sunset period.

Aside from a product specific one FHFA does not intend to conduct further reviews on new framework quality control processes under its 2014 examination plan, but will consider incorporating this activity into the 2015 plan.  Also FHFA has not examined any of the systems that Freddie Mac identified in its risk analysis that it needed to establish or enhance to support the new framework nor scheduled exams for Fannie Mae of its needed quality control processes and systems.   

In summary, OIG found that FHFA mandated a 36-month sunset Period for representation and warranty Relief without validating the GSEs' analyses or performing sufficient analysis to appropriately balance financial risk between the GSEs and Sellers

Based on this finding OIG recommends that FHFA:

1.   Assess the current state of the GSE's critical risk assessment tools, representations and warranties tracking systems, and other systems, to determine whether they are appropriate to minimize financial risk from the new framework. The results should document any areas of identified risk, planned actions, and corresponding timelines to mitigate each area identified and provide an estimate of when each GSE will be reasonably equipped to work safely and soundly within the new framework.

2.   Perform a comprehensive analysis to assess whether financial risks associated with the new representation and warranty framework are appropriately balanced between the GSEs and sellers. This analysis should be based on consistent transactional data across the GSEs and identify potential costs and benefits to them and document consideration of the FHFA's objectives.

FHFA partially agreed with the first recommendation and will request that the GSEs provide information about needed operational changes to accomplish this and will take this information into account in developing its examination plans for 2015.

As to the second recommendation, FHFA disagrees and says it will not perform an analysis of the financial risks associated with the new framework.  It claims that revisiting decisions about the sunset periods and the related payment history requirements may have adverse market impact on future framework revisions and may not align with its objective of increasing lending to consumers consistent with GSE safety and soundness.