The Federal Housing Finance Agency (FHFA) submitted a 180 page Report to Congress on Tuesday detailing the findings of the agencies 2009 examination of Fannie Mae, Freddie Mac, the Federal Home Loan Banks (FHLBanks), and the Office of Finance.  The Report, submitted by Acting FHFA Director Edward J. DeMarco, was the second since the agency was created to supervise the four financial institutions.

FHFA Director Ed DeMarco said that the study found that Fannie Mae and Freddie Mac remain "critical supervisory concerns."  While the two government sponsored entities, which have been operating under federal conservatorship since 2008, have remained active in supporting the secondary mortgage market and are critical to supporting the ongoing functioning of the nation's housing finance system, DeMarco said that they would not be able to continue this function without ongoing financial support from the U.S. Department of the Treasury.

According to the report, the FHLBanks met their purpose during the financial crisis, but advances made to their members steadily declined throughout the year.  The examination also found that the financial condition and performance of half of the 12 FHLBanks was less than adequate.  The Seattle Bank was, in fact, deemed "undercapitalized.

The six banks with a less than adequate financial condition had heavily invested in private-label mortgage-backed securities (MBS).  These banks incurred credit-related impairment charges of more than $200 million in 2009.  Four of these banks have negative accumulated other comprehensive income, mostly reflecting noncredit impairment on private label MBS, in excess of their retained earnings.  At the Seattle and Boston banks this excess is large and DeMarco said he was led to deeming the Seattle FHLBank as undercapitalized even though it had capital in excess of required regulatory minimums.

The FHLBanks, however, met their public purpose during the financial crisis, providing an increasing allotment of advances through 2007 and 2008.  These advances topped $1 trillion in September, 2008 but as liquidity has increased along with bank deposits these advances have been steadily declining, falling to $631 billion by the end of 2009.  The decline has continued into 2010.

The FHLBank's advance business continues to operate without credit losses but its MBS investments remain a significant concern.  These investments have adversely affected  the overall operations of some banks where dividends have been suspended as has the ability to repurchase or redeem stock. At the end of 2009 all 12 banks exceeded the minimum leverage ratio by having at least 4 percent capital-to-assets with the weighted average regulatory capital to assets ratio for the system at 5.9 percent.

Both Freddie Mac and Fannie Mae were given a composite rating of "critical concern" in the examination  This designation is given to Enterprises with critical safety and soundness concerns, exhibiting severe financial, nonfinancial, operational, or compliance weaknesses and requiring more than normal supervision to ensure deficiencies are addressed.

In summarizing the condition of the two GSEs, the report said that levels of capital and capital adequacy, a key measure of safety and soundness, cannot be used because the two entities operate in a conservatorship with financial support from the government.  Both enterprises, it said, have depleted all of their shareholder's equity, with the negative balances of those accounts being offset by Treasury's investments under the Preferred Stock Purchase Agreements.

The report said the status of the GSEs must be looked at in a before-and-after conservatorship context in several operational areas; book of business, pricing, operational deficiencies, and mission.

Book of Business
The key factor leading to conservatorship was the GSE's investment in private-label MBS.  Their decline in market value drove losses and reductions in net worth throughout 2008.  These investments caused Freddie Mac to lose $27 billion of net worth and because of its smaller investments in the private-label MBS, had a similar but less severe impact on Fannie Mae.

Almost all of the credit losses in the guarantee book during 2009 were the result of mortgages originated pre-conservatorship and the majority was from mortgages the 2005 to 2007 vintage.  Each Enterprise has and will continue to realize credit losses from mortgages originated in the several years prior to conservatorship.

Post-conservatorship, in accordance with guidance provided by FHFA to ensure conservation of assets and minimization of future loss, the GSEs have tightened their underwriting standards, including raising the floor on FICO scores and lowering the allowed loan-to-value ratio.  As a result, the overall performance on new mortgage guarantees has improved.  Serious delinquency rates for 2009 originations are a fraction of the rates for earlier vintages after comparable periods of aging.

Pricing
Each GSE has made changes in their national guarantee fee pricing to correct for the under pricing of credit risk in prior years and to reflect risks in the current environment of falling house prices and other factors.  During 2009, in light of rising delinquency rates and forecasts of continuing declines in housing prices, the GSEs updated their pricing models several times to reflect changes in the market environment.Operational Deficiencies

There has been progress made in addressing material deficiencies in 2009; however, the examination assigns a composite rating of critical concerns for each enterprise and describes a number of areas where additional work is needed.

Fannie Mae's challenges were intensified by the Making Home Affordable loan modification programs and by a growing catalogue of owned real estate.  High turnover of executive and senior management in the loss mitigation and asset disposition areas were also a concern.

In the case of Freddie Mac, the report said its credit related problems have been compounded by competing priorities because of critical finance and accounting projects as well as the same loss mitigation programs affecting Fannie Me and a similarly increasing volume of owned real estate.

The report said the progress was made during the year addressing corporate governance and liquidity management issues; however, still of concern are the operational risk factors outlined above and credit risk arising from increasing loss severities.  There are also concerns about the viability of key counterparties, especially private mortgage insurers; and the reliability of models used for risk management and key accounting estimates.

Mission
The Enterprises have continued to serve a vital role in the secondary mortgage market since conservatorship, especially in the absence of private capital.  In 2009 their share of single-family originations was 76 percent, up from 73 percent in 2008.  Both also play a significant role in foreclosure prevention which is critical both to their own financial condition and to stabilizing the housing market.

DeMarco reminded Congress of statements he made in February of this year that the Enterprises will be limited to continuing their existing core business activities and taking actions necessary to advance the goals of the conservatorship, but that operating in conservatorship cannot be a long term solution and that the Administration and Congress must together decide on "the future of the housing finance system, including an ultimate resolution of the Enterprises' future."