BACKGROUND

The Enterprises support the secondary mortgage market by purchasing residential mortgage loans from lenders. They may hold these mortgages as their own investments or bundle them into mortgage-backed securities (MBS)—typically with guarantees covering principal and interest payments—for sale to other investors. MBS issued or guaranteed by government agencies (e.g., the Government National Mortgage Association) or government-sponsored enterprises, such as the Enterprises, are referred to as “agency MBS.” In 2011, the agency MBS market of $5.5 trillion was more than four times larger than the non-agency MBS market.

Selling and Servicing Loans for the Enterprises

The Enterprises’ mortgage-related business is considerable. The Enterprises owned or guaranteed $4.6 trillion of the nation’s estimated $10.3 trillion in outstanding single-family mortgages as of September 30, 2011. In other words, the Enterprises own or guarantee almost half of all mortgages on homes in the United States.

The same lenders that sell these mortgages to the Enterprises frequently also service the loans for them. Servicing includes much of the day-to-day work involved with mortgages, such as:

• Collecting payments from borrowers;

• Maintaining escrow accounts for property taxes and insurance; and

• Handling mortgage modifications, defaults, and foreclosures.

In 2011, the Enterprises worked with over 2,000 servicers.

Doing such a large volume of business with multiple counterparties poses risks to the Enterprises when their success depends on the counterparties’ stability.3 Indeed, as demonstrated by the recent housing crisis, counterparties can fail rapidly in response to adverse market conditions.
Enterprises’ Counterparty Risks

Since 2007, the Enterprises have suspended or terminated business with more than 40 seller/servicers on their high-risk watch lists. Although such suspensions and terminations are designed to protect the Enterprises from one or more specific risks and to stop the creation of additional exposure, they can leave them vulnerable to a variety of other financial risks, including:

• Loss of guarantees on counterparties’ work. Counterparties commit (i.e., they make representations and warranties when they sell loans to the Enterprises) to follow Enterprise requirements for underwriting mortgage loans. If they do not comply, the Enterprises can have them repurchase the loan(s) they sold to the Enterprises for up to full face value or terminate their servicing rights. However, if a counterparty sold the Enterprises mortgage loans that did not meet standards (e.g., borrowers lack the necessary income to pay their mortgages), the Enterprises could lose the full or partial loan amounts if borrowers default following the counterparty’s failure.

• Increased tax and insurance payments. If a servicer fails and its portfolio cannot be transferred quickly, an Enterprise may have delayed access to the tax and insurance escrow accounts, potentially resulting in late fees for not making timely payments for the underlying properties’ insurance and tax obligations as the servicer normally would have done.

• Legal fees and associated costs.

o Counterparty bankruptcy cases can be complex and take years to complete. The Enterprises need specialized legal representation to make, negotiate, and settle claims in competition with other entities seeking to recover funds from the counterparty (e.g., mortgage payments and escrow accounts held at the time of the failure/bankruptcy filing).

o In addition, there is risk inherent in moving mortgages to other servicers, including expenses incident to the transfer of servicing responsibilities from the failed servicer (e.g., costs associated with the physical movement of loan files from one servicer to another).

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