On Thursday the Federal Housing Finance Agency (FHFA) Office of Inspector General (OIG) released the results of three evaluations of FHFA's oversight of the two government sponsored enterprises (GSEs) Freddie Mac and Fannie Mae. FHFA is the successor conservator of the GSEs which were placed into government conservatorship in August 2008. The other two evaluations, one of the oversight of the GSEs' charitable giving and the other of Fannie Mae's participation in an industry convention, were reported earlier this morning.
This audit concerns the extent of FHFA's oversight of Fannie Mae's single-family mortgage underwriting standards. Specifically, OIG reviewed FHFA's written policies for oversight of these standards and oversight of Fannie Mae's internal controls over its implementation of the standards. OIG also plans to contract for additional audit coverage related to the effectiveness of quality controls used by the GSEs to determine compliance with underwriting standards.
The GSEs buy mortgages from lenders and either keep them as investments, or package and sell them to other investors. During the first 10 months of 2011, Fannie Mae purchased nearly 2.1 million loans valued at $427 billion. To be eligible for purchase, a mortgage must satisfy the GSEs' underwriting standards or have their approval to vary from them. Fannie Mae's underwriting standards, which it refers to as eligibility requirements, derive from a combination of Congressional charter-based and traditional risk-based criteria. Charter-based criteria would include original principal balance limits and loan-to-value ratios while risk based criteria focus on collateral, capacity, and creditworthiness.
Notwithstanding the housing boom and subsequent housing collapse, Fannie Mae's basic underwriting standards for purchase-money loans secured by single-family, principal residences have not changed materially since 2006. However, Fannie Mae has authorized a number of variances that have impacted those underwriting standards and the numbers of these have fluctuated substantially over time. In 2005 when standards were loose, Fannie Mae authorized over 11,000 variances. Between January 2005 and August 2007, Fannie Mae began rescinding variances, which tightened underwriting standards. Fannie Mae had over 600 variances as of September 2011. These variances from underwriting standards effectively relax those standards and this contributed to the credit losses and credit-related expenses suffered by Fannie Mae in recent years.
As an alternative to qualifying mortgage loans for Fannie Mae's purchase by manually meeting its underwriting standards (or authorized variances from them), most lenders rely on automated underwriting software. Fannie Mae has developed its own software, DU, which lenders use to evaluate whether prospective mortgage loans are eligible for sale to the Enterprise. In 2010, over 1,500 lenders used DU, and over 71% of the loans delivered to Fannie Mae were approved using the software. Lenders may also develop their own underwriting software, but Fannie Mae must approve and grant a variance for its use.
Fannie Mae's single-family mortgage business involves a nationwide network of approximately 2,500 approved mortgage lenders and servicers. From January to October 2011, Fannie Mae acquired over 2 million loans valued at over $427 billion. To oversee this large venture, Fannie Mae has established an oversight process that includes lender/servicer assessment, quality assurance review and remediation for purchased loans, and fraud detection.
- Fannie Mae oversees its mortgage sellers and services with a team that reviews sellers' documents and visits their offices.
- Fannie Mae does not conduct compliance reviews on loans prior to purchase but its quality assurance group reviews samples of loans post-purchase to ensure they comply with the terms and conditions under which they were purchased.
- A Mortgage Fraud Program (MFP) team reviews cases of suspected fraud, works to remediate it and recoup losses, and report fraud to appropriate authorities.
As conservator, FHFA assumed all of the powers of the GSEs' shareholders, directors, and officers. In November 2008, FHFA delegated day-to-day decision-making back to the GSEs' officers and directors while identifying particular activities that required its approval including those that involve capital stock, dividends, increased risk limits, material changes in accounting policy or reasonably foreseeable increases in operational risk and those that will likely cause significant reputational risk.
In July 2009, FHFA further refined its role with a regulation clarifying its delegation of day-to-day decision-making authority. The regulation requires FHFA approval of all new GSE products and activities but states that "new products" do not include any modification to underwriting criteria for those mortgages purchased or guaranteed by the GSEs.
OIG found that FHFA does not have a formal process for reviewing underwriting standards and variances but it informally reviews and comments on Fannie Mae's proposed credit policy changes. However, FHFA's review mechanism was not designed to assess underwriting standards and variances and does not assess them in a systematic manner.
FHFA also reviews, comments on, and approves Fannie Mae's Corporate Scorecard. OIG says that the scorecard is not a substitute for a detailed consideration of underwriting standards and variances and that Fannie Mae's Corporate Scorecard for 2012 does not include explicit goals for underwriting standards.
In contrast to FHFA's decision not to affirmatively review underwriting standards, the FHFA believes that feedback and approval of the Corporate Scorecard is an appropriate conservatorship action. However, underwriting standards and variances control the mortgages that Fannie Mae acquires, not the scorecard's goals, and there are many factors that contribute to the better performance of recent mortgage vintages.
OIG concluded that FHFA can strengthen its oversight by creating formal processes for reviewing both GSEs' underwriting standards and variances from them and enhance is guidance for planning and conducting its examinations of the GSEs' underwriting quality control.
To summarize, OIG's audit determined the following:
- FHFA lacks policies and procedures controlling its process to review underwriting standards and variances.
- Guidance for targeted examinations of GSE compliance with underwriting standards can be enhanced.
FHFA's targeted examinations that included Fannie Mae's quality control of compliance with underwriting standards which began in 2011 is a positive step but additional guidance is needed to ensure the success of underwriting examinations going forward which should include criteria for independent testing of quality control.
Additionally, FHFA's most recent quarterly risk assessment cited credit risk as a critical concern due in part to the high volume of seriously delinquent loans. This number seems to be declining and later vintage loans are performing well but credit risk is noted to be increasing due to Fannie Mae's RefiPlus program with its high LTV ratios. The new HARP program may exacerbate this risk. FHFA needs to address the increasing credit risk through development of comprehensive examination guidance.
Fannie Mae also continues to authorize over 600 variances yet FHFA does not formally review them and thus is not in a position to appreciate their nature and scope. Obtaining information about the variances would help to educate FHFA about existing increased credit risk and may improve examination guidance.
Following its audit, FHFA recommends that:
- FHFA's Division of Housing Mission and Goals formally establish a policy for its review process of underwriting standards and variances including escalation of unresolved issues reflecting potential lack of agreement.
- The Division of Examination Program and Support enhance existing guidance for assessing adherence to underwriting standards and variances from them.
In OIG's opinion, these recommendations apply to FHFA's responsibilities to Freddie Mac as well as to Fannie Mae.
FHFA responded to the OIG report, agreeing with both recommendations and identifying proposed actions to address them and OIG states it found the actions sufficient to resolve the recommendations, subject to further review.
