The Federal Housing Finance Agency (FHFA) submitted its 2013 Report to Congress on Thursday.  The Report covers the Agency's regulation of the Federal Home Loan Banks (FHLBanks) and its activities as both conservator and regulator of the government sponsored enterprises (GSEs) Freddie Mac and Fannie Mae.

Most of the report is a collation of previous releases.  Some aspects--such as an explanation of the Strategic Plan for the GSEs, or the changes in the Senior Preferred Stock Purchase Agreements--have been covered repeatedly.  Rather than summarize the lengthy reprise of FHFA and GSE activities across the year we are summarizing instead the results of FHFA's evaluations of the two GSEs. 

In 2012 FHFA evaluated the GSEs' financial conditions, earnings, liquidity, and efforts taken to mitigate losses in its single and multifamily portfolios and assessed their responses to continued stress in the mortgages markets and its effect on their risk profile, performance, and condition.   FHFA uses three approaches in its evaluation; ongoing monitoring, targeted examinations, and risk assessments.

Based on the results of the evaluation FHFA assigned both Fannie Mae and Freddie Mac a composite rating of critical concerns, the same as in 2011.  The critical weaknesses are evidenced by their lack of capital, the quality of legacy assets, level and extent of internal control break-downs, uncertainty over the sustainability of their recent financial performance, and the nature of their conservatorship status.  An additional concern specific to Freddie Mac was operational challenges with legacy systems and insufficient business recovery capabilities. Because of their contractual agreements neither GSE can use its earnings to augment its capital.

Recent improvements in the GSEs financial performance is driven by favorable trends in housing prices, the strong books of business, increased guarantee fees, and actions taken to reduce credit losses and improve profitability.  The companies continue to operate with an excessive amount of credit risk in the single family portfolio and FHFA continues to have concerns about the condition of key counterparties and the effect of the accelerated wind-down of the retained portfolio.

GOVERNANCE:

Fannie Mae's rating for governance was downgraded from 2011 because unresolved system issues continue to make Fannie Mae difficult to manage, impede efficiency and raise questions about the reliability and effectiveness of its modeling and forecasting of data.

Freddie Mac's rating of significant concerns was unchanged from 2011.  Its board of directors continues to perform satisfactorily and a new CEO has strengthened the executive team.  Continued uncertainty around the future state of housing finance poses heightened strategic risk.

SOLVENCY

The rating for solvency was suspended upon the beginning of the conservatorship for both GSEs

EARNINGS

Both GSEs were rated of significant concern for earnings, an upgrade for both.

Fannie Mae generated $17 billion in earnings in 2012 and projects 2013 will be profitable but the sustainability of earnings is a concern given national economic challenges and possible actions of Congress regarding both the economy and the future of the GSEs.  There is also concern about the Company's business lines' ability to provide a risk-adjusted return sufficient to attract outside capital.

Freddie Mac reported net income of $11 billion in 2012 but the primary driver was an $8.6 billion decrease in provisions for credit losses.  In the last quarter of 2012 it reported a benefit for credit losses from reducing loan loss reserves, which is not a sustainable source of income.

CREDIT RISK

FHFA assigned a critical concerns rating to both GSEs in the area of credit risk because of the credit characteristics of their legacy books of single-family loans and the potential effect of economic uncertainty, sustainability of performance of the post 2009 book of business and the credit risk posed by institutional counterparties.  Counterparty risk remains high and is concentrated in mortgage insurers and mortgage banks.  Although the overall direction of credit risk has decreased, delinquent loans and real estate owned continue at high levels.  FHFA also mentioned the expected higher risk of HARP loans in connection with the Freddie Mac evaluation.

MARKET RISK

A significant concerns rating was assigned Fannie Mae's market risk, the same as in 2011. As the portfolios shrink distressed assets are becoming an increasingly large portion and issues related to liquidity and pricing of distressed mortgages will remain an ongoing challenge.  Fannie Mae's pricing models introduce a high level of uncertainty into the risk management profile of the portfolio.

Freddie Mac's rating of significant concerns is unchanged from 2011.  Although the quality of risk management is adequate the quantity of risk is high relative to earnings and capital.  The GSE's retained portfolio continues to be a concern.  Freddie Mac has improved the risk management framework and took measures to address turnover and human capital risk, however the reliability of risk metrics and human capital risk continue as a concern.

OPERATIONAL RISK

As in 2011 Fannie Mae is assigned a significant concerns rating as the quantity of operational risk is high and will remain elevated through the year due to economic uncertainty, changes in information systems, the service environment and remediating compliances deficiencies related to the Sarbanes-Oxley Act. 

There is also operational risk attached to the number of FHFA initiatives being implemented including the securitization platform.  Fannie Mae has begun transferring large servicing assignments to nonbank companies that introduce a new level of risk.  It has a number of efforts underway to address operational shortcomings but these are long term solutions.

Freddie Mac's operational rating of significant concern is an upgrade as the quality of this risk management is improving but risk levels are high and increasing including continued dependence on key people, insufficient business recovery capabilities, competing priorities for information technology resources and high reliance on manual controls.

MODEL RISK

Fannie Mae was assigned a significant concerns rating.  Volatile housing and mortgage markets have significantly increased model risk.  Those models used for estimating crucial variables that worked well in the past have failed in the current economic environment.

Freddie Mac's rating of significant concerns is unchanged.  FHFA expressed concerns about model development and the GSE's ability to set and meet schedules for timely release of new and upgraded models.  These concerns arise from a prolonged history of delays of its primary credit model and turnover in key management positions.