Government-sponsored mortgage repurchasers Fannie Mae and Freddie Mac are making progress correcting problems that led to accounting and management scandals, but remain “a significant supervisory concern,” regulators said in their annual report to Congress.

Fannie’s and Freddie’s continued efforts to fix internal control and systems problems are hindering their ability to respond to changes in the market, including the demand for new loan products, the report by the Office of Federal Housing Enterprise Oversight (OFHEO) said.

OFHEO Director James Lockhart noted the government-sponsored entities (GSEs) haven’t reached a key milestone indicating that they’ve put their problems behind them: a return to timely filing of financial statements with the Securities and Exchange Commission.

“I am pleased to report that both companies are working hard to achieve this goal, but they still have much to do,” Lockhart said in a letter to members of the House Committee on Financial Services and the Senate Committee on Banking, Housing and Urban Affairs.

The committee on March 29 approved a bill strengthening oversight of Fannie and Freddie, which Lockhart praised as “a balanced approach.”

Freddie hasn’t produced timely financial reports since 2002, and Fannie since 2004. Freddie released 2006 results in March, and is working toward returning to quarterly public reporting later in 2007. Fannie recently restated earnings for 2002 through 2004 — adjusting them downward by $6.3 billion — and plans to release financial statements for 2005 this year.

After accounting problems that eventually forced both companies to restate their earnings surfaced several years ago, the GSEs were saddled with 30 percent additional capital requirements and limits on the growth of their portfolios.

Fannie Mae agreed a year ago to pay a $400 million fine and limit its mortgage portfolio to $727.7 billion until OFHEO approves an increase. In August, Freddie Mac agreed to a $724 billion cap on its mortgage portfolio until it returns to filing regular financial reports.

Despite that, double-digit growth in guarantees of mortgage-backed securities helped the GSEs grow their combined books of mortgage business by 7.7 percent in 2006, to $2.53 trillion. Together with their loan portfolios, the GSEs have a $4.3 trillion presence in the mortgage market, Lockhart said.

However, “The need to focus on internal control and systems problems continues to inhibit the (GSEs’) ability to respond to changes in the market, the economy and accounting standards,” the OFHEO report concluded.

GSEs profit, manage risk

Both Fannie and Freddie were profitable in 2006. Net income at Freddie Mac was up 4 percent to $2.2 billion, reversing three consecutive years of decline. Fannie Mae hasn’t released earnings, but information the company has submitted indicates it “achieved a reasonable degree of profitability,” OFHEO reported.

Credit risk at Fannie and Freddie remained low in 2006, “but was increasing at year-end,” the report said.

The single-family delinquency rate, which was up at the end of 2005 after hurricanes Katrina and Rita, declined during 2006, to .53 percent at Freddie Mac and .65 percent at Fannie Mae. Freddie Mac’s $36.2 billion in capital at the end of 2006 amounted to 4.5 percent of assets, exceeding minimum requirements by $2.6 billion. After being “significantly undercapitalized” from 2002 to 2004, Fannie Mae boosted capital to $42.3 billion during 2006, exceeding requirements by $4.2 billion.

At Fannie, higher-risk products such as interest-only, subprime, Alt-A and negative-amortization loans have grown to represent 20 percent of the book of business, the report said.

Fannie came under fire from OFHEO for concentrating too much of its business in the hands of too few companies, which could increase its exposure to risk.

“Risk from counterparties and concentrations in similar types of counterparties represent a significant risk” for Fannie, the report said.

Nine mortgage servicers process 71 percent of Fannie’s $2.1 trillion servicing book, with Countrywide alone representing 21 percent of guaranteed loans. Countrywide also services 20 percent of Fannie’s $90 billion investment in private-label mortgage-backed securities.

The top seven mortgage insurers provide insurance for 17 percent of Fannie’s $2.5 trillion book of business, OFHEO noted.

Freddie’s overall asset quality is “strong,” and the GSE “prudently manages” potential overexposure to too small a pool of mortgage sellers, servicers, and insurers.

The road ahead

At Freddie Mac, OFHEO said, “intensive efforts” have been made to address internal control weaknesses, but “several key initiatives” have not progressed as planned.

Issues requiring continued strong oversight at Freddie include improving internal controls, information technology, credit risk management, and risk oversight.

OFHEO characterized operational risk at Freddie as “high,” saying it “continues to be a primary supervisory concern.”

“All internal control-related material weaknesses and significant deficiencies identified during 2005 or prior years’ annual audits remain outstanding,” OFHEO said. “The internal control structure remains fragmented, incomplete, and in some cases, undocumented.”

An April 2006 plan to return Freddie to timely financial reporting suffered “ineffective planning and inconsistent execution.”

The OFHEO report identified “aggressive time schedules, lack of independent quality assurance, inadequate management reporting, cultural issues of responsibility and accountability and project management deficiencies” as factors in the “insufficient progress” made toward implementing Freddie’s plan.

At Fannie Mae, “operational risk is high and controls are weak,” but improvements were made in 2006, OFHEO said.

Most of Fannie’s back-end and accounting applications “are aging platforms and legacy business applications,” the report said, which has “significantly contributed to an ineffective internal control environment.”

The aging systems make it difficult to produce accurate and timely performance and risk reports, and “significant work” remains to integrate “restatement, catch-up and get-current operations” with current production operations.

Resources were strained at Fannie Mae throughout 2006, the report said, because of the burden of maintaining normal business operations while also coping with “inconsistent data repositories, legacy platforms and applications that are unable to meet changing business, market and regulatory requirements.”

OFHEO said Fannie Mae needs to hire additional staff in risk management and some business units, with understaffing problems most acute in single-family credit. While Fannie is able to provide “adequate service to clients for traditional loan products,” it faces difficulties developing new loan products.

Fannie must improve management communications, reporting and internal controls; limit interest rate risk, and beef up infrastructure, OFHEO said. However, “major progress” was made in several areas of board and management supervision, including implementing new organizational structures independent oversight.

“Management has substantially improved the number and expertise of management and staff,” the report said. “Personnel numbers have increased by about 18 percent over the past two years, with the increase focused on staff to strengthen controls, governance and risk management.”

More than 35 percent of Fannie’s openings in senior management and 53 percent of all officer positions have been filled by outside hires, the report said.

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