FHFA Sends Annual Report to Congress on GSEs, FHLBanks

As required under the Housing andrnEconomic Recovery Act (HERA), the director of The Federal Housing FinancernAgency (FHFA) submitted the agency’s annual Report to Congress on the two governmentrnsponsored enterprises (GSEs) for which it is responsible and for the FederalrnHome Loan Banking System (FHLBanks.)  Inrnaddition to a lengthy recounting of the performance of the regulated entitiesrnduring the course of 2011, FHFA also provided an assessment on their safety andrnsoundness including information on any material deficiencies in theirrnoperations, their overall operational status, and an evaluation of theirrnperformance in carrying out their respective missions.</p

FHFA reported that it had conducted an examinationrnof both GSEs as to their financial safety and soundness and overall riskrnmanagement practices on a framework known as GSEER which stands for Governance,rnSolvency, Earnings, and Enterprise Risk which comprises credit, market, andrnoperational risk management.  The agencyrnassigned rating of critical concern to both Fannie Mae and Freddie Mac in arnnumber of areas and ratings of substantial concerns in others.  </p

In the case of Fannie Mae, the reportrnsays that the GSE “exhibits critical financial weaknesses as evidenced by itsrnpoor performance and condition and prospects”. rnCredit risk remains high but is somewhat mitigated by the higher qualityrnof the single family book of business since 2009.  Business operations are vulnerable torndisruption, especially by human capital risk, and capital is wholly dependentrnon the support of the U.S. Treasury.</p

In the case of Freddie Mac FHFA says itsrncredit risk remains high, the control structure is weak, human capital risk isrnelevated, and their capital is also wholly dependent on the Treasury. </p

The most significantrnrisks facing Fannie Mae are credit risk, human capital risk, dependence on arnlegacy infrastructure that needs to be updated, and the need to execute thernstrategic plan for the conservator ships. rnFannie Mae’s management and its board were responsive throughout 2011 tornFHFA findings and are taking appropriate steps to resolve issues the reportrnsays.  However Fannie Mae must continuernto identify and proactively reduce the risk and complexity of its businessrnactivities, focus on loss mitigation and foreclosure prevention, and maintainrnsound underwriting criteria for single family and multifamily portfolios.</p

FHFA assigns a limited concernsrnrating to Fannie Mae governance, an upgrade from the last examination and isrnworking with the company to identify a new president and chief executivernofficer.  This solvency or capitalrnclassification for ratings remains suspended as it has been since the beginningrnof conservatorship, but FHFA assigns earnings a critical concern rating.  Fannie Mae’s net losses increased in 2011 to $16.9rnbillion from $14 billion in 2010, driven primarily by high provisions for creditrnlosses.  New delinquencies along withrnfurther declining home prices resulted in a substantial increase in loan lossrnreserves.  These reserves increased $10.6rnbillion to $76.9 billion in 2011.  Inrnaddition a steep decline in long-term interest rates led to mark-to-marketrnlosses on derivatives used for hedging purposes.</p

Fannie Mae’s credit risk also ratesrna critical concern.  Although risk isrnhigh and the quality of risk management is adequate and the level of risk isrndecreasing the principal concerns are the credit characteristics of Fannie Mae’srnlegacy 2005 to 2008 vintage single-family book of business, opportunity’s tornimprove multifamily risk management, and continued weakness of its mortgagerninsurer counterparties.</p

FHFA assigns market risk arnsignificant concern rating, an upgrade from 2010.  Risk levels are high but the quality of riskrnmanagement is adequate.  The concerns arernlargely centered around increased balance sheet illiquidity because of thernamount of distressed assets and whole loan portfolios resulting from lossrnmitigation activities, the need to strengthen attendant risk managementrnpractices, and the continued negative effects on earnings from the mark-to-marketrnnegative effects from derivative contracts. rnHowever liquidity and funding risks are low and the related riskrnmanagement is adequate.</p

Operationalrnrisk is a significant concern, another upgrade from 2010.  The level of risk is high and increasing butrnthe quality of operational risk management is adequate although Fannie Mae needsrnto further strengthen project management. rnIts uncertain future, legacy information technology, manual processes thatrnreduce its flexibility, and the requirement to implement the strategic planrnkeep operational and process risks at elevated levels.  However the company improved risk managementrnin 2011 by installing new operational risk leadership, implementing a riskrnmanagement framework, centralizing the reporting structure and otherrninnovations.</p

In conducting its examination ofrnFreddie Mac, FHFA focused on matters previously identified as requiringrnattention and the board and management’s response to deficiencies andrnweaknesses identified by internal and external audits.</p

Governance was considered arnsignificant concern in the examination of Freddie Mac.  The company’s enterprise risk managementrnstructure continues to benefit from a recent redesign however management isrnfinding it difficult to maintain an adequate control structure because ofrnincreased employee turnover and reliance on manual processes.  The quality of information the Board ofrnDirectors receives has improved and FHFA is working with the board to identifyrna new CEO.  The board should continue tornfocus on the key risks and issues facing Freddie Mac including the effectrnemployee turnover has on its ability to manage its information technology.</p

Freddie Mac received a critical concernsrnrating on earnings.  Total revenuesrnincreased slightly in 2011 and credit related expenses and mark-to-marketrnlosses on derivatives also increased.  Derivativernlosses were offset partly by interest rate related gains on assets.  </p

Credit risk was also considered a criticalrnconcern although it is decreasing and its risk management is consideredrnadequate.  As with Fannie Mae, thernprincipal concerns center around the GSE’s 2005 to 2008 vintage single familyrnloans, coupled with underwriting and controls in the multifamily business line,rnweak mortgage insurer counterparties, and increased concentration ofrncounterparty risk.   FHFA said that thernhigher quality of Freddie’s more recent single family business and management’srnsuccess in loss mitigation is alleviating some concerns. </p

Market risk is considered a significantrnconcern.  The level is high relative tornearnings and capital for the quality of risk management is adequate.  The retained portfolio’s growing proportionrnof illiquid assets is increasing risk because of the level of distressed assetsrnand whole loan portfolios.  These assetsrnare less liquid, causing prepayment modeling difficulties and less reliablerninterest rate risk metrics.  Humanrncapital risk in the investment and capital markets group and continued negativerneffects from the mark-to-market derivative contracts are also a concern.  </p

Operational risk is a critical concernrnas it is high and increasing and the quality of risk management needsrnimprovement.  Human capital risk and the dependencernon legacy operational and information technology infrastructure are among thernhighest risks facing the GSEs.  </p

Model risk is a significantrnconcern but while the level is high it is stable.  FHFA’s concerns include the timeliness ofrnmodel valuations and the efficacy of models in the current economicrnenvironment. </p

FHFArnfollowed up a special review in October of 2011 with a directive requiringrnFreddie Mac to phase out its retained attorney network and to work with FHFArnand Fannie Mae through the Servicing Alignment Initiative to develop andrnimplement consistent requirements, policies, and processes for default and foreclosure-relatedrnlegal services.</p

FHFArnreported that as of the end of 2011, the FHLBanks exceeded the minimum leveragernratio by having at least 4 percent capital-to-assets.  The weighted average regulatory capital to assetsrnratio for the system was 6.9 percent in 2011 compared to 6.5 percent in 2010.  All FHLBanks were profitable for the year andrnthe system’s advance business continues to operate with no credit losses.  However the quality of the FHLBanks’rninvestments in private label mortgage backed securities (MBS) remains arnsignificant concern.  Exposure to suchrnsecurities dropped by 20 percent during 2011 as did the credit chargesrnassociated with the securities.</p

Duringrn2011 two FHLBanks were under consent orders because of their financialrnconditions.  The FHLBank of Seattle saw deteriorationrnin the value of its private label MBS starting in 2010 while Chicago had beenrnoperating under a cease and desist order since October 2007.  Seattle remains under the enforcement actionrnbut Chicago’s order was removed in early 2012.</p

Thernoverall all scale of the FHL banks advance operations continued to decline inrn2011 reaching $418 billion at year end compared to $479 billion at the end ofrn2010.  Investments in private label MBSrnhave adversely affected the overall operation of some banks reducing theirrnability to repurchase or redeem stock as the banks shrunk.  FHFA has taken action where needed to addressrnthis problem.

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