The same agencies that sell mortgages tornthe GSEs frequently also service the loans. rnIn 2011 the GSEs worked with over 2,000 servicers and, FHFA OIG pointsrnout that doing such a large volume of business with multiple counterpartiesrnposes risks when the GSEs success depends on the counterparties’rnstability.  In the recent housingrndownturn the GSEs found that counterparties can fail rapidly in response tornadverse market conditions.</p

Since 2007 the GSEs have suspended orrnterminated more than 40 sellers/servicers on their high-risk watch lists andrnwhile these actions are intended to protect the GSEs from one or more specificrnrisks and block new exposure, they can leave the GDEs vulnerable to otherrnfinancial risks.</p<ul class="unIndentedList"<liIfrncounterparty loans do not perform after the counterparty fails, the GSEs havernno recourse to collect on the counterparty reps and warranties.</li<liIfrna servicer fails and its portfolio cannot be transferred quickly the GSE mayrnhave delayed access to escrow accounts and may incur late fees for failing tornpay tax and insurance obligations on time.</li<liCounterpartyrnbankruptcy cases can be complex and take years to complete. The GSEs need specialized legal representationrnto shepherd their claims through the courts and to recover mortgage paymentsrnand escrow accounts. </li<liTherernis also significant risk inherent in moving mortgages to other servicersrnincluding expenses incident to the transfer of servicing responsibilities andrncosts for the physical movement of files from servicer to servicer. </li</ul

These risks are magnified by the volumernof business done with a given counterparty and due to consolidation in thernmortgage industry and the number of lenders that have closed; the GSEs’rnbusiness has become increasingly concentrated. rnFor example, as of September 2011 the GSEs’ top 10 seller/servicers werernresponsible for 70 percent of their mortgage portfolio and the GSE’srnacknowledged in their recent financial filings that they face significant risksrnfrom the sudden collapse of large counterparties.</p

Tornaddress the risks, the GSEs screen counterparties before working with them,rnrequire them to follow certain selling and servicing rules, and monitor theirrnongoing performance, financial condition, and compliance.  For example, they may require counterpartiesrnto meet minimum financial capacity standards, conduct operational reviews, andrnuse this information to determine the terms of their relationship such asrnsetting limits on financial transactions. They also have guides that outlinerncounterparties responsibilities, review samples of loans after purchase andrnhave fraud programs to review suspect cases, identify fraud risk, and work tornremediate it and recoup losses.</p

Despite such precautions there are stillrnrisks so the GSEs protect themselves by establishing counterparty limits andrnidentifying and monitoring high-risk counterparties.  Each GSE has developed systems to identifyrnhigh risk parties and as of September 2011 had identified more than 300 with anrnestimated exposure of $7.2 billion.</p

Each GSE takes ad hoc, remedial actionsrnin response to specific deficiencies they identify such as reducing theirrncredit exposure to the counterparty or requiring additional collateral.  These actions, however, do not always preventrnthe GSEs from suffering losses. Inrnaddition, employing ad hoc risk reduction tools is different thanrnsystematically incorporating those tools into a formal and comprehensive planrnthat accounts for various adverse economic scenarios.</p

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

A contingency plan is a risk managementrnmechanism designed to guide organizations to respond to particular events.  Contingency plans may not prevent losses in arncase like the example above, but may reduce the risk exposure.  In spite of the obvious advantages ofrncontingency plans and that fact that FHFA has identified high risk servicer/sellers,rnFHFA has not required the GSEs to prepare contingency plans to avoid orrnmitigate the consequences of counterparty deterioration or failure. Such plansrnshould be developed based on each GSE’s assessment of the risks posed by itsrncounterparties, which could include individual plans or group plans forrncounterparties based upon size or risk tier. The objective of the plans shouldrnbe to restore operations quickly and seamlessly with approved counterparties,rnproactively anticipating alternative courses of action while minimizing thernimpact of counterparty failure. </p

FHFA does have a draft examination manual that providesrnguidance to its examiners on how to review contingency plans and has been fieldrntesting it in anticipation of the GSEs developing plans.  Although FHFA recently asked the GSEs torndevelop such plans it has not published guidance requiring them to do so or guidancerngoverning plan contents.  </p

FHFA OIG recommends that FHFA issuernstandards for the GSE to develop comprehensive contingency plans to high-riskrnand high-volume seller/servicers and that it finalize its examination guidancernregarding contingency planning.

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