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Office of Inspector General notice

FHFA watchdog sounds alarm on loan loss reserves

Fannie, Freddie delayed in adopting new accounting practices

fire alarm

The Office of Inspector General has raised concerns that Fannie Mae and Freddie Mac are ignoring potential losses on overdue single-family residential mortgages since it’s taken the enterprises three years to adopt new risk management and accounting practices.

Classification of asset classes according to risk characteristics is a critical factor in evaluating the government-sponsored enterprises’ overall financial safety and soundness.

As a result, the Federal Housing Finance Agency recognized the importance of risk management, given that a majority of the GSEs’ assets are concentrated in loans and issued an advisory bulletin for the enterprises to classify any outstanding loan balance in excess of the fair value of the property, less cost to sell, as a ‘loss’ when the loan is no more than 180 days delinquent. 

The FHFA made clear that a change in the risk management policies of Fannie Mae and Freddie Mac single-family mortgages should be made. Yet, it’s been three years and no accounting change has been adopted.

"To date, the advisory bulletin, which was issued 15 months, has not been fully implemented," explained Steve Linick, a regulator with the OIG.

He added, "To date, neither Fannie Mae nor Freddie Mac has publicly disclosed the financial statement impact of implementing these accounting changes."

One of the major concerns is that given the significance of the loan loss reserve for estimating both GSEs’ accounts, the government is running the risk of a key safety and soundness practice that could have a negative impact on overall loss reserves.

Additionally, the advisory bulletin states that it “embodies a basic principal in GAAP that losses should be recognized on loans that are deemed uncollectible and that there should be no delay in loss recognition of probable incurred losses.”

However, this will not be fully implemented until January 2015, three years after the issue was initially brought to the attention of the enterprises.

"The issuance of the advisory bulletin was a positive step," Linick said. "We have concerns about the delay in its implementations until 2015."

While both GSEs have posted better quarterly and yearly profits as the housing market continues to rebound, such a critique has created some market woes.

"There’s no doubt if the GSEs are required to adopt a new accounting standard for loan loss reserves that is more conservative than the current construct that it will negatively impact short-term performance and subsequent dividend payments to Treasury," cautioned Tim Rood, partner and managing director with The Collingwood Group.

He added, "In the second quarter of 2013 alone Fannie Mae reduced its loan loss reserve amount to roughly $7 billion, and reserves are $14 billion lower than their fourth quarter 2011 highs. The reductions reflect better market conditions and more effective loss mitigation tactics by the enterprises."

As a result, the OIG recommends that FHFA require Fannie Mae and Freddie Mac to report to its conservator and OIG the estimated impact on their financial statements as if the advisory bulletin took effect immediately. Following this, the enterprises need to provide reports on a quarterly basis.

Additionally, FHFA needs to provide OIG "justification for agreeing to delay the advisory bulletin’s implementation."

The FHFA responded to the OIG’s request and feels that the GSEs can put the advisory bulletin into action given the current timeline of implementation.

"Like all regulators of large, complex financial institutions, FHFA recognizes that changes in a significant policy require considerable changes to systems and operations that could take time to complete in a safe, sound and well controlled manner," said John Greenlee of FHFA in a memorandum response letter. 

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