The Federal Housing Finance Agency's Office of Inspector General (FHFA OIG) has recommended that FHFA issue standards for the two government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac to develop contingency plans for its high risk sellers and servicers and finalize its examination guidance regarding contingency planning.

FHFA OIG recently looked how well FHFA is managing and overseeing the GSEs in areas related to the risk posed to the GSEs by their sellers and servicers (counterparties).  The report issued by FHFA-OIG on this evaluation is the third to come out of the office this week related to GSE servicing.

The GSEs own or guarantee $4.6 trillion of the nation's $10.4 trillion in outstanding single family mortgages which they acquire from lenders and bundle into mortgage-backed securities (MBS), typically with guarantees, for sale to other investors.  Those MBS with guarantees from the GSEs or from the Government National Mortgage Association are referred to as "agency MBS" and currently outnumber the non-agency MBS market four to one.

The same agencies that sell mortgages to the GSEs frequently also service the loans.  In 2011 the GSEs worked with over 2,000 servicers and, FHFA OIG points out that doing such a large volume of business with multiple counterparties poses risks when the GSEs success depends on the counterparties' stability.  In the recent housing downturn the GSEs found that counterparties can fail rapidly in response to adverse market conditions.

Since 2007 the GSEs have suspended or terminated more than 40 sellers/servicers on their high-risk watch lists and while these actions are intended to protect the GSEs from one or more specific risks and block new exposure, they can leave the GDEs vulnerable to other financial risks.

• If counterparty loans do not perform after the counterparty fails, the GSEs have no recourse to collect on the counterparty reps and warranties.
• If a servicer fails and its portfolio cannot be transferred quickly the GSE may have delayed access to escrow accounts and may incur late fees for failing to pay tax and insurance obligations on time.
• Counterparty bankruptcy cases can be complex and take years to complete. The GSEs need specialized legal representation to shepherd their claims through the courts and to recover mortgage payments and escrow accounts.
• There is also significant risk inherent in moving mortgages to other servicers including expenses incident to the transfer of servicing responsibilities and costs for the physical movement of files from servicer to servicer.

These risks are magnified by the volume of business done with a given counterparty and due to consolidation in the mortgage industry and the number of lenders that have closed; the GSEs' business has become increasingly concentrated.  For example, as of September 2011 the GSEs' top 10 seller/servicers were responsible for 70 percent of their mortgage portfolio and the GSE's acknowledged in their recent financial filings that they face significant risks from the sudden collapse of large counterparties.

To address the risks, the GSEs screen counterparties before working with them, require them to follow certain selling and servicing rules, and monitor their ongoing performance, financial condition, and compliance.  For example, they may require counterparties to meet minimum financial capacity standards, conduct operational reviews, and use this information to determine the terms of their relationship such as setting limits on financial transactions. They also have guides that outline counterparties responsibilities, review samples of loans after purchase and have fraud programs to review suspect cases, identify fraud risk, and work to remediate it and recoup losses.

Despite such precautions there are still risks so the GSEs protect themselves by establishing counterparty limits and identifying and monitoring high-risk counterparties.  Each GSE has developed systems to identify high risk parties and as of September 2011 had identified more than 300 with an estimated exposure of $7.2 billion.

Each GSE takes ad hoc, remedial actions in response to specific deficiencies they identify such as reducing their credit exposure to the counterparty or requiring additional collateral.  These actions, however, do not always prevent the GSEs from suffering losses. In addition, employing ad hoc risk reduction tools is different than systematically incorporating those tools into a formal and comprehensive plan that accounts for various adverse economic scenarios.

FHFA OIG references in particular a single seller/servicer identified by both GSEs as high-risk and with whom they have a combined exposure of $3.5 billion. Although the GSEs have taken steps to protect themselves from immediate risks, they have not, the report says, prepared a systematic plan to respond to more disastrous potential eventualities that would require the GSEs to manage the transfer of thousands of mortgages on short notice to another servicer.

A contingency plan is a risk management mechanism designed to guide organizations to respond to particular events.  Contingency plans may not prevent losses in a case like the example above, but may reduce the risk exposure.  In spite of the obvious advantages of contingency plans and that fact that FHFA has identified high risk servicer/sellers, FHFA has not required the GSEs to prepare contingency plans to avoid or mitigate the consequences of counterparty deterioration or failure. Such plans should be developed based on each GSE's assessment of the risks posed by its counterparties, which could include individual plans or group plans for counterparties based upon size or risk tier. The objective of the plans should be to restore operations quickly and seamlessly with approved counterparties, proactively anticipating alternative courses of action while minimizing the impact of counterparty failure.

FHFA does have a draft examination manual that provides guidance to its examiners on how to review contingency plans and has been field testing it in anticipation of the GSEs developing plans.  Although FHFA recently asked the GSEs to develop such plans it has not published guidance requiring them to do so or guidance governing plan contents. 

FHFA OIG recommends that FHFA issue standards for the GSE to develop comprehensive contingency plans to high-risk and high-volume seller/servicers and that it finalize its examination guidance regarding contingency planning.