When the Federal Housing Finance Agency implemented new representation and warranty policies for Fannie Mae and Freddie Mac on Jan. 1, 2013, it did so in a rushed and flawed manner that exposes the government-sponsored enterprises to significant risk, the FHFA’s watchdog said in a new report.
In a new report from the FHFA’s Office of the Inspector General, the OIG said that the FHFA mandated a new rep and warranty framework for the GSEs and implemented it “despite significant unresolved operational risks to the Enterprises.”
The policy, which was originally proposed by the FHFA’s Acting Director Ed DeMarco in September 2012, included several changes to the GSEs rep and warranty policies, including those relating to credit underwriting and eligibility of the borrower and property that were formerly effective for the life of the loan.
The new framework also granted repurchase relief to sellers if the loans had acceptable payment history of 12, 36, or 60 months, depending on the loan product and when it was acquired.
When the changes were announced, DeMarco indicated that the taxpayers would be better protected from future losses because of the more conservative approach by the GSEs.
“Ultimately, better quality loan originations and underwriting, along with consistent quality control, help maintain liquidity in the mortgage market while protecting Fannie Mae and Freddie Mac from loans not underwritten to prescribed standards,” said DeMarco said at the time. “These efforts contribute to a firm foundation for a new, sustainable housing finance system for the future.”
But according the FHFA-OIG, the changes were implemented far too quickly and did not allow the GSEs to fully implement the processes, procedures and systems either would need to operate within the new framework by the established start date of Jan. 1, 2013.
According to the OIG report, Freddie Mac said, in a risk analysis published in August 2012, that it would need two years to fully update its systems, including the creation of two new systems to track loan level data and to allow sellers to receive feedback on mortgage risk and appraisal quality prior to loan delivery, to support the new guidelines.
“Despite FHFA’s awareness that Freddie Mac would not have the systems and tools in place it deemed necessary to help identify non-compliant loans and reduce credit losses, FHFA continued with its Jan. 1, 2013, implementation for the new framework,” the OIG report said.
Fannie Mae also told the FHFA that it needed a significant amount of time to update its systems and, as of July, still had not fully enhanced its systems to the appropriate level, according to the OIG report. Fannie said that the completion and full rollout of those systems is projected to occur in late 2015.
As with Freddie Mac, the FHFA did not determine whether Fannie Mae had the necessary systems in place to support the framework, the OIG report said.
“As a result, there is an inherent risk for potential errors and the Enterprises may experience credit losses that otherwise may have been mitigated through use of contractual remedies such as repurchases,” the OIG said in its report.
“FHFA directed the Enterprises to implement the new framework without allowing sufficient time for them to fully implement and test pre- and post-loan delivery risk assessment tools, systems used to track loan information related to the new framework, and systems that support the Enterprises’ quality control processes,” the OIG report continued.
“As a result, there is potentially unmitigated risk of errors in the new loan review framework and the Enterprises may experience credit losses that otherwise could have been avoided both by the structure of the framework and the systems and processes employed to implement it.”
The OIG report calls the reps and warrants changes a “sea-change” to the GSEs’ risk management programs and quality control processes. “The financial magnitude is based on the Enterprises’ level of single family business following the implementation of the new framework,” the OIG said in its report.
“For example, in 2013, the first year for the new framework, the Enterprises bought approximately 5.6 million loans from sellers with a total unpaid principal balance exceeding $1.13 trillion.”
The OIG report also found that the FHFA mandated a 36-month “sunset” period for rep and warranty relief, “without validating the Enterprises’ analysis or performing sufficient additional analysis to determine whether financial risks were appropriately balanced between the Enterprises and sellers.”
The OIG report also said that the January 2013 implementation “did not adequately consider operational risks related to implementation of an appropriate infrastructure to support the new framework through upfront monitoring of loan quality and post-purchase quality control prior to the sunset period.”
The report also said, “FHFA’s decision-making process concerning the new framework was not supported by complete, thorough, and consistent analysis.”
According to the OIG report, the “lack of due diligence on FHFA’s part is significant,” because it impacts the GSEs ability to:
1. Conduct quality control reviews earlier in the loan process, generally between 30 to 120 days after loan purchase
2. Evaluate loan files on a more comprehensive basis to ensure a focus on identifying significant deficiencies
3. Leverage data from the tools currently used by Fannie Mae and Freddie Mac to enable earlier identification of potentially defective loans as mandated by FHFA
“Without adequate systems and processes, achieving a positive economic outcome for the Enterprises through implementation of the new framework is uncertain,” the OIG report said. “Conversely, the sellers stand to benefit from the lack of preparation as loans start to pass the sunset dates without thorough screening of their quality.”
The OIG suggests two changes that the FHFA should implement to address these issues. First, the OIG recommends that the FHFA assess whether the GSEs’ current operational capabilities minimize financial risk that may result from the new framework. Second, the OIG recommends that the FHFA assess whether the financial risks associated with the new framework, including the sunset periods, are balanced between the Enterprises and the sellers.
As is custom with the OIG reports, the OIG forwarded a copy of its initial findings and recommendations to the FHFA for response.
The FHFA partially agreed with the first recommendation, saying that it would take the OIG recommendations into account when it was forming its operational plans for 2015.
“Although FHFA’s planned corrective action is potentially responsive to OIG’s recommendation, it is not clear what specific steps FHFA plans to take or how it plans to document the results of the recommended assessment, including areas of identified risk, planned actions, timelines to mitigate each area of identified risk, and estimates of when each Enterprise will be reasonably equipped to perform loan quality review safely and soundly within the new framework,” the OIG report said.
The FHFA did not agree with the second recommendation, saying “revisiting its decisions regarding the new framework sunset periods and related payment history requirements to prepare an analysis of the financial risks associated with a previous release of the framework may have adverse market effects on future revisions to the framework, and may not align with the FHFA objective of increased lending to consumers consistent with Enterprise safety and soundness.”
The OIG report does note that the FHFA did agree to enhance its documentation and analysis going forward, including identifying and addressing risks for the GSEs, and surrounding decisions that will impact the representation and warranty framework.
“Further, FHFA stated it will continue to evaluate, document, and revise the framework, taking into account stakeholder comments and various market factors in order to improve credit access for consumers, consistent with Enterprise safety and soundness,” the OIG report said.
“In this regard, OIG did not see that FHFA fully considered the economic impact and in turn the safety and soundness of the Enterprises in the analysis supporting the initial release of the framework in September 2012. Thus, the actions identified by FHFA are positive steps and can go a long way toward meeting the intent of OIG’s recommendation.”
But the OIG cautioned that it remains concerned that the FHFA has not fully developed the potential impact of the rep and warranty guidelines on the GSEs and the taxpayers.
“The potential consequences of continued implementation of the new framework are substantial and warrant more careful consideration by FHFA,” the OIG said.
“Without a comprehensive analysis to assess potential economic impacts on the Enterprises associated with the framework and its revisions in order to establish a baseline to measure performance, FHFA is unable to make fully informed decisions regarding the need for and financial risks associated with further updates to the framework as the agency stated it would do.”