Operational Risk Assessments Freddie Mac Multifamily Asset Management and Operations

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1 Operational Risk Assessments Freddie Mac Multifamily Asset Management and Operations January 2017 Operational Classifications: Rankings: Forecast: Commercial Mortgage Special Servicer and Commercial Mortgage Trust Advisor Special Servicer: MOR CS2 (Affirmed) Trust Advisor: MOR TA3 (Affirmed) Stable Both Rankings Analysts: Michael Gutierrez, Michael S. Merriam, Rationale Morningstar Credit Ratings, LLC affirmed its MOR CS2 commercial mortgage special-servicer ranking and its MOR TA3 commercial mortgage trust-advisor ranking for Freddie Mac Multifamily Asset Management and Operations. Freddie Mac is a government-sponsored enterprise operating under a conservatorship established on Sept. 6, 2008, under the auspices of the Federal Housing Finance Agency, or FHFA. Morningstar affirmed its rankings for Freddie Mac based on these factors: Special Servicing: Reporting: We have a positive view of Freddie Mac s capabilities to provide accurate and timely reporting and the overall quality of its asset-level reporting content. In particular, Freddie Mac effectively handles the exchange of pertinent information both with its seller/servicers and its investors in multifamily mortgage K-Deal and SB-Deal securitizations. Excellent Recovery Results With Multifamily Assets: During the first half of 2016, Freddie Mac resolved eight multifamily loans representing a total of approximately $108.7 million of unpaid principal balance. During this time period, the company experienced no real estate owned, or REO, liquidations. Additionally, the average hold times on resolved assets signify an expeditious disposition process. While this volume represents a significant decline from prior periods, we believe this is primarily due to the continued reduction of its legacy balance sheet portfolio coupled with the strong performance of its securitized transactions. Well-Controlled Asset Management and Sound Audit Function: Freddie Mac employs diligent practices and procedures for soundly controlled asset management to mitigate risk. The company s audit practices for its multifamily division also remain solid. They encompass not only a periodic formal internal audit, but also quarterly self-administered, yet independent, internal audits performed by the multifamily division s enterprise risk management group within its governance and business services department that test special-servicing compliance with Freddie Mac s own policies and procedures and any K-Deal and SB-Deal transaction requirements. Transparent Asset-Resolution Practices and Sound Conflicts of Interest Management: Freddie Mac conducts thorough performance reviews and audits of its seller/servicers, which inform and educate the staff at each entity of Freddie Mac s policies, procedures, and requirements for servicing Freddie Mac-sponsored loans. This two-way interaction not only mitigates the risk of errors but also enhances efficiencies by maintaining close communication with Freddie Mac s network of seller/servicers. Freddie Mac's expanded

2 servicing standard requirements for its seller/servicers, as well as requiring companies to have a chief servicing officer certifying that the standard is being met, further strengthens the agency s oversight and enhances the customer service value for its borrowers. Because Freddie Mac has no affiliations with subordinate class purchasers on its standard K-Deal securitizations and has no ownership interests in or affiliations with third-party vendors, the company has no discernible conflicts of interest. Additionally, Freddie Mac has strict procedures for selecting and approving third-party vendors with a well-delineated hierarchy of delegated authority for such decisions. Ongoing Efforts to Enhance and Consolidate Legacy Systems: Freddie Mac continues to enhance its asset-management system, Freddie Mac Multifamily SMART (Streamlined Management Analytical and Reporting Tool). Freddie Mac developed the SMART system to ultimately encompass the functionality that still resides in some stand-alone legacy applications. It made solid progress in those efforts throughout 2014 and introduced new applications to fortify its surveillance and asset-management processes in In 2016, the company rolled out a business-to-business portal that allows the seller/servicer network to eliminate dual entry for tracking borrower requests. In addition, it has greatly enhanced its disaster-recovery preparedness by establishing a geographically remote recovery site and a hot site for its key employees. It also increased disaster recovery testing frequency to a quarterly schedule. It has also greatly reduced recovery times for key business processes involving cash management. However, the company s stated allowable maximum time frames to recover some noncash functions still exceed industry norms. Staffing Levels: The company appears to have sufficient staff resources to keep pace with its recent asset transfers. In fact, its overall ratio of assets/asset manager stood at 11/1 for loan assets as of June 30, The company had one REO asset at that time. Trust Advisor: Solid Capabilities Based on Diligent Track Record Overseeing Servicers and Special Servicers: We have a favorable view of Freddie Mac s proven experience in reviewing the work and recommendations of its seller/servicers relating to activities such as borrower consents, asset status reports, and major decisions both for its balance -sheet loans and its securitized transactions. Thorough Review Practices of Seller/Servicers to Monitor Adherence to Freddie Mac Requirements: Freddie Mac employs an extensive and well-designed performance review and audit program for its seller/servicers. Freddie Mac s program proactively guards against seller/servicers errors or omissions that could lead to losses for Freddie Mac or its securitization investors. Familiarity With the CREFC Investor-Reporting Package: Freddie Mac s management and professional staff possess a sound knowledge of the Commercial Real Estate Finance Council, or CREFC, investor-reporting content, data templates, and decision-making considerations required of special servicers in securitized transactions. As of June 30, 2016, Freddie Mac s active special-servicing portfolio was approximately $205.1 million and consisted of 22 loans and one REO asset. Forecast The forecast is Stable for both rankings. Morningstar expects Freddie Mac to remain an effective special servicer for its balance-sheet portfolio and to conduct proactive surveillance on its securitized transactions. We will continue to monitor its ongoing technology initiatives and expect the company to realize greater efficiencies as it seeks to further integrate applications and eliminate stand-alone systems. The operation also is suitably positioned to perform the roles and responsibilities of a trust advisor in securitized transactions. 2

3 Table of Contents Page Company Profile and Business Overview...4 Operational Infrastructure...5 Organizational Structure...5 Management and Staff Experience...7 Asset-Manager Workload Ratios...8 Training...9 Audit, Compliance, and Procedural Completeness...10 Legal Liability and Corporate Insurance...11 Technology and Disaster Recovery...11 Special-Servicing Portfolio Administration...12 Asset-Review Process...13 REO Property Management...14 Vendor Oversight...14 Borrower Consent Requests...15 Managing Conflicts of Interest...16 Asset-Resolution and Recovery Performance...16 Investor and Master-Servicer Reporting...19 Trust-Advisor Administration...19 Ranking Definitions...21 Disclaimer

4 Company Profile and Business Overview Congress chartered Freddie Mac in 1970 as a government-sponsored enterprise with a public mission to expand the availability of homeownership to a broader range of the population, as well as increase the supply of affordable multifamily housing stock. Its statutory charge is to provide liquidity, stability, and affordability to the U.S. housing market. Freddie Mac carries out this mission by purchasing mortgage loans originated by its network of seller/servicers and pooling and securitizing them in transactions. Freddie Mac provides guarantees of certain payments to investors. Freddie Mac is prohibited from directly originating loans. Consequently, the multifamily division of Freddie Mac contributes to the company s overall mission by providing an ample supply of affordable rental housing through the purchase of mortgages backed by rental properties containing five or more units. It conducts those purchases through a network of approved seller/servicers and Targeted Affordable Housing seller/servicers, which collectively have more than 150 branches nationwide. It employs approximately 770 mortgage professionals in four regional offices in New York City, Los Angeles, Chicago, and McLean, Virginia, where it also maintains its corporate headquarters. Regional satellite offices have recently been added in Austin, Texas; Irvine, California; Atlanta; Bellevue, Washington; Denver; Fort Lauderdale, Florida; and Houston. Through the first half of 2016, the company funded approximately $26.9 billion in new business volume, which provided financing for approximately 2,000 multifamily properties representing more than 357,000 apartment units, and has securitized roughly $27.2 billion of multifamily loans into its K-Deals and SB-Deals. On Sept. 6, 2008, Freddie Mac was placed under conservatorship under the direction of the FHFA, which currently regulates its operations. Under this arrangement, the FHFA has assumed all powers of the board, management, and shareholders, and it directly controls some of the company s business activities and strategies. It has delegated certain authority to Freddie Mac s board of directors and to management to oversee and conduct ongoing operations. On Sept. 7, 2008, the company, through the FHFA as conservator, entered into a purchase agreement with the U.S. Treasury Department, which was amended most recently on Aug. 17, Under the terms of the agreement, Freddie Mac issued senior preferred stock and warrants to purchase shares of common stock as consideration for the Treasury to provide funding under certain terms and conditions. As of June 30, 2016, the company maintained a positive net worth of $2.1 billion, which has resulted in no additional funds being drawn on under the purchase agreement. Since 2008, the company has paid aggregate dividends of $99.1 billion including the $.09 billion September 2016 dividend obligation. On May 13, 2014, the FHFA issued its 2014 Strategic Plan and a 2014 Conservatorship Scorecard. The Strategic Plan updates the agency s vision for the future role of Freddie Mac and Fannie Mae, while the annual Conservatorship Scorecard strives to put forth metrics by which its success in implementing its vision can be measured. The 2014 Strategic Plan reformulates the agency s three basic goals for stewardship of both Freddie Mac and Fannie Mae: Continue, in a safe and sound manner, its foreclosure-prevention and homeownership-retention efforts and maintain credit availability for new and refinanced mortgages to create a stable and sustainable national housing finance market. Reduce taxpayer risk by aiding the return of private capital to the national housing finance markets. Form a new uniform single-family securitization platform for both Freddie Mac and Fannie Mae that other participants could use in the secondary mortgage market. Also, with the appointment of former U.S. Rep. Mel Watt as the new FHFA director in 2014, there is a new emphasis on housing affordability, which is expected to open the door for new products for the multifamily division. In 2014, the agency announced the launch of a lending program for manufactured housing developments as well as small balance loans and it has already approved 11 seller/servicers to originate and administer the latter product. The 2016 Conservatorship Scorecard requires Freddie Mac to maintain the dollar volume of new multifamily 4

5 business for each enterprise at or below a specified cap (originally $31 billion), excluding certain affordable housing loans, loans for small multifamily properties, loans for manufactured housing rental communities, loans on seniors housing assisted living properties, and loans to finance energy or water efficiency improvements. On Aug 18, 2016, FHFA announced an increase in the 2016 multifamily lending caps for Fannie Mae and Freddie Mac from $35 billion to $36.5 billion. A previous market change adjustment was announced by FHFA on May 4, 2016, increasing the multifamily lending caps from $31 billion to $35 billion. However, there remains significant uncertainty as to whether or when the company will emerge from conservatorship given there is no specific termination date. In our view, the future structure and operations of both the multifamily division and Freddie Mac itself will depend on the actions of Congress and the administration, but we believe significant changes in the near term are unlikely. As of June 30, 2016, Freddie Mac had a multifamily whole loan portfolio of $41.4 billion, a multifamily investment securities portfolio of $15.3 billion, and a guarantee portfolio of $141.5 billion. Table 1 Freddie Mac Historical Special-Servicing Portfolio Volume* June 30, 2016 Dec. 31, 2015 Dec. 31, 2014 UPB ($ Mil) Loans UPB ($ Mil) Loans UPB ($ Mil) Loans Loan Portfolio REO Portfolio Total Portfolio Volume *All held on balance sheet. Operational Infrastructure Organizational Structure Freddie Mac s multifamily division oversees all production, asset management, strategic planning, and risk management for the multifamily line of business. The division is further supported by the company s legal, finance, human resources, operations and information technology, communications, and enterprise risk-management departments. The following groups comprise the multifamily division: Production and Sales Underwriting and Credit Affordable Sales and Investments Asset Management and Operations Multifamily Executive Capital Markets Investments and Advisory Business and Offerings Management 5

6 The asset-management and operations group manages relationships with seller/servicers and monitors risk and loss mitigation efforts for the multifamily portfolio. It consists of the following units: Operations and Operational Risk Servicer and Client Management Special Servicing Surveillance Group Executive The operations and operational-risk unit manages the final delivery, settlement, and loan-accounting functions for the asset-management and operations group. It is also charged with internal oversight and customer compliance management. The servicer and client-management unit is charged with the collection of data, the loan-boarding process, insurance-related matters, and seller/servicer client-relationship management. The surveillance unit monitors the credit quality and performance of the multifamily loan portfolios and monitors guarantees on Freddie Mac s bond and securitization programs. The special-servicing unit monitors and manages all postpurchase transaction activity for the multifamily business through its three teams: securitized transactions, structured transactions, and asset-resolution, REO, and borrower transactions. An important initiative for the asset-management and operations group in 2014 was the establishment of the servicing standard as a means to prioritize the borrower experience in its securitized transactions. Freddie Mac developed this standard, set forth in its seller/servicer guide and incorporated into each of its pooling and servicing agreements for its securitized transactions. Among other things, it ensures transparency and communication among all involved parties in these transactions to help improve the borrower experience as well as protect the Freddie Mac brand by strengthening the company s oversight over all postsecuritization activities. This involved, among other things, standardizing processes for portfolio and securitized loans as well as submission forms for seller/servicers. The effort has focused especially on streamlining the consent approval process, and, to that end, the company has required each seller/servicer to designate a chief servicing officer who certifies each consent request before submission. The company is also realigning its fee structure with its seller/servicers to provide added incentive for the servicers to enhance the quality of services to its borrowers. This has added another level of review and quality control to the consent review process. In response to feedback from its seller/servicers, Freddie Mac made significant changes to its servicing-standard program. It created for itself the role of servicing consultant and added the concept to its pooling and servicing agreements, which allows for greater transparency into the company s credit and servicing philosophy and methodology. It also added a master-servicer surveillance fee to provide incentive for servicers to increase capacity and retain servicing. Finally, it streamlined the property-management company change review and approval process. As of July 31, 2016, the asset-management and operations group employed a staff of 206 with a senior team possessing an average of nearly 24 years of commercial real estate experience. Staff within the group generally average 13 years of commercial real estate experience. This included 47 people dedicated to the special-servicing and surveillance functions. Within special servicing there were a total of 23 asset managers with an average of 20 years of commercial real estate experience. These asset managers are grouped into three distinct teams. The first team handles asset resolutions, REO, and borrower transactions. The second team handles structured transactions, which includes hedge management and valuation, risk share collateral monitoring, transaction management, support and credit enhancement administration, and reporting. The third team handles warehouse consent requests and K-Deal postfunding transaction oversight. The asset resolution, REO, and borrower transactions group consists of five asset managers who receive support from attorneys in the company s legal department. One director manages the pipeline and team as well as signs off on all major credit decisions per the internal 6

7 approval authority matrix. The remaining members of the team are responsible for managing owned assets from foreclosure through final liquidation; handling nonperforming loan assets, restructurings, and modifications; and monitoring low-risk maturing loans. Chart 1 Freddie Mac Multifamily Division: Asset Management and Operations and Operational Risk Organizational Structure Management and Staff Experience As of June 30, 2016, the average industry experience for special servicing and surveillance senior management was nearly 32 years, which was virtually unchanged from 31 years as of June 30, The average experience of middle-level managers was 23 years, which is unchanged from the prior year. The head of the asset-management and operations group has nearly 42 years of experience in the commercial mortgage industry. Staff experience averaged 12 years, which is a slight drop from 14 years in 2015, but still a significant increase from six years as of June 30, As of June 30, 2016, asset managers average experience increased to 29 years from 28 years. 7

8 Table 2 Special Servicing/Surveillance Management and Staff: Average Years of Experience as of June 30, 2016 Total Industry Tenure at Freddie Mac Senior Management Middle Management 23 9 Staff 12 7 Asset Managers Management and Staff Turnover During the first six months of 2016, the special-servicing and surveillance units had six departures and hired eight new employees. During the last six months of 2015, the units had three departures and hired five new employees. Morningstar calculated that the units had a moderate 14% turnover rate during the first half of 2016, which is consistent with an approximately 14% turnover rate for full-year However, excluding intracompany transfers, that turnover rate is actually 2% for the first half of As of June 2016, all six terminations were voluntary and likewise for the three terminations in the second half of Table 3 Management and Staff Turnover Rates* First-Half 2016 Second-Half 2015 Special Servicing/Surveillance Special Servicing/Surveillance Total Staff - Beginning of Period (# of Positions) Total Turnover (%) 14 (6 positions) 14 (5 positions) Involuntary (%) 0 0 Voluntary (%) Management Only (%) 2 3 Staff Only (%) New Hires (# of Positions) 8 11 Total Staff - End of Period (# of Positions) *Staff departures divided by number of staff at beginning of period. Asset-Manager Workload Ratios As of June 30, 2016, Freddie Mac had four asset managers with 22 unresolved loans and one REO property, for an approximate 6/1 ratio of assets to asset manager. As of Dec. 31, 2015, Freddie Mac dedicated two asset managers to manage loans and two asset managers to manage 8

9 and sell REO assets. The ratio of REO assets to asset manager stood at 1 to 2 as of that date, with the excess capacity directed toward loan resolution and other duties. Assessment: The organizational structure of Freddie Mac s asset-management and operations department remains well-designed to address the company s special-servicing requirements for its multifamily portfolio. We also believe that its senior and middle managers have a high degree of industry-related experience. Employee turnover in the first half of 2016 remains consistent with that for full-year 2015 and is well within industry standards. The asset-manager headcount has also remained consistent with that at year-end 2015, which reflects strong performance in the company s portfolio. We believe that Freddie Mac continues to carefully manage its staffing levels in a prudent and cost-efficient manner. The company s ratio of total assets per asset manager is below the industry average among special servicers and indicates excess capacity should a higher volume of assets materialize. Likewise, the ratio of loans to loan asset manager is below the industry average and may also indicate excess capacity if the company experiences an increase in loan workouts. Freddie Mac resolved or otherwise transferred out of special servicing a total of 14 loans during the first six months of 2016, while it resolved or otherwise transferred 10 loans in the last six months of The company converted one loan into REO during the second half of 2015, but it did not sell any REO assets through the first half of Training The company provides a curriculum of ongoing, formalized training activities for all personnel through its talent development team, which is staffed with 13 full-time employees. Senior management annually assesses employee needs to determine appropriate curriculum offerings. In the case of asset management and operations, a dedicated course developer designs training related to those duties. The asset-management and operations department drafted or sponsored the development of 24 hours of training specific to its staff in 2016, up from 14 hours in 2015 and 10 to 12 hours in A proprietary system called MyFMU tracks and coordinates training. This application offers training and development courses in four distinct categories called knowledge centers: business expertise, managing people, personal effectiveness, and tools and technology. Each category offers a variety of web-based and instructor-led courses, resources, and recommended reading related to that topic. More than 150 instructor-led courses and more than 400 web-based trainings are offered through MyFMU. Employees also use the application to track individual courses and hours of instruction completed. There is a webpage for the asset-management and operations group to communicate training objectives, curriculum planning, and course offerings to its staff. Freddie Mac has no official minimal annual hourly requirement for training for its employees, but it expects asset-management and operations employees to complete at least 40 hours of training annually. Management reviews employee training hours on a quarterly basis to ensure hourly targets are achieved. As of September, assetmanagement and operations employees generally had completed 51 hours of formal training. Additionally, in the first half of 2016, the group s employees dedicated to surveillance and special servicing completed over 40 hours of training, while they completed more than 66 hours of training in 2015 on the MyFMU system. The company expects to meet or exceed these training hours by the end of Assessment: Freddie Mac has a robust and well-structured training regimen for its staff with ample resources and technology to keep its staff up to date with the latest job-related skills and information. While Freddie Mac does not mandate a minimum number of training hours, we consider the average hours of training undertaken by staff in 2015 and the first half of 2016 to be higher than similarly ranked special servicers. 9

10 Audit, Compliance, and Procedural Completeness An outside auditing firm examines Freddie Mac as a public company. The FHFA also audits the company on an annual basis for safety and soundness risk. In addition to these outside audits, the company maintains an internal-audit division with a direct reporting line to the audit committee of its board of directors and a dotted line to the company CEO. The governance and business services unit within asset management and operations coordinates the division s internal audits with the corporate audit. In 2014, the company merged its enterprise risk-management unit into governance and business services to reduce redundancies so all risk management for asset management and operations is now conducted by this group. All functions in the company s multifamily division have been rated with a medium or low risk score, so they are audited every two to four years. At least annually, the internal-audit group discusses with the company s external auditors as well as the management of each auditable entity to develop the audit scope and schedule for each division. Although the internal-audit schedule for asset management and operations is two to four years, the company follows the three lines of defense concept of risk management. This strategy calls for risk management by the business as its first line of defense and independent risk oversight as a second line. This risk oversight is conducted by the governance and business services and compliance groups. The third line is its own internal audit process. In addition to these audits, the governance and business services area performs quarterly examinations of all functions deemed to involve credit risk. The operational risk/internal control department assesses how departmental management handles operational, financial, and control risks related to changes in personnel, technology, processes, or outside events. This includes testing over internal controls for financial reporting. Finally, the multifamily operations unit in asset management and operations manages internal and external relationships with oversight, audit, and regulatory agencies and checks for any compliance gaps between the activities of the multifamily division and enterprisewide requirements. The company conducted two audits in 2015 affecting asset management and operations, specifically covering special servicing, surveillance, data management, and loan purchase operations functions. The two audits received a satisfactory audit opinion with two minor reportable findings. In 2016, the department conducted an audit of the data and rules management department, which was graded satisfactory. It also conducted an audit of four different functions within asset management and operations: loan servicing, cash desk, operational close, and data and rules management. This audit cited two minor findings. The governance and control team coordinates and populates the multifamily division s policies and procedures on a shared drive. In addition, it provides security access to that drive based on defined user roles. Directors and above in the multifamily division ensure procedures related to processes they manage are reviewed and approved annually or changed as needed according to a delegated authority matrix. The multifamily credit policy department approves all divisional procedures to provide alignment with credit policies. Assessment: Freddie Mac s asset-management and operations department continues to undergo an extensive audit regimen. Its recent reposition of enterprise risk management functions into the governance and control unit serves to increase efficiencies and reduce redundancies in the audit process. Although the frequency of internal audits for asset management and operations is less than that of most similarly ranked entities, we believe that the company successfully maintains multiple layers of review and controls and provides testing by multiple parties internally and externally, who work together to provide strict oversight over both operational and financial risk. The asset-management and operations department s internal audits have helped to mitigate operational risks based on the frequency, scope, and outcome of its various auditing activities. In addition, policies and procedures remain thorough, are welldesigned to address all of the multifamily division s servicing duties, and are effectively managed to control content revisions. 10

11 Legal Liability and Corporate Insurance Freddie Mac reported that it was not involved as a defendant in any material lawsuits involving its special servicing general practices and operations. Furthermore, it reported that it has directors and officers, and general liability coverage for its multifamily REO in amounts that appear adequate. However, the company stated it does not carry errors and omissions coverage because it does not provide professional advice or consultation in the course of its business. Assessment: The company s insurance coverage amounts are adequate for its business needs. Overall, Freddie Mac, based on its representations, effectively addresses its corporate insurance requirements and is not subject to any outstanding material servicing lawsuits. Technology and Disaster Recovery Freddie Mac s multifamily division relies primarily on a suite of legacy applications and databases called Multifamily Processing System and MultiSuite to support its core business processes and serve as a system of record for its loan portfolios. The company also developed a proprietary asset-management system for asset management and operations called the Freddie Mac Multifamily SMART system (as defined in the Rationale section of this report), which functions as the principal asset-management software by enabling data analysis in support of the management and disposition of assets in the retained and securitized portfolios. The system enables asset managers to prepare resolution plans directly in the application itself. All risk rating workflow for both retained and securitized portfolios are now housed in SMART, and, since January 2014, the system maps risk ratings to established FHFA risk classifications. The asset-management and operations group has also successfully integrated its net present valuation model, formerly a stand-alone application, into the SMART system. As planned, the company has built a new centralized data warehouse to house data from all applications. In addition to these two main applications, Freddie Mac uses the following ancillary systems: Property Reporting System enables seller/servicers and Freddie Mac to submit property and financial data. Insurance Compliance Tool provides a mechanism for submission of insurance coverage data and waivers, and contains review, approval, and tracking mechanisms. Multifamily Securities Investor Access provides both investors and asset managers access to securities and underlying collateral data. Consent Request Tracker enables monitoring of a servicer s and Freddie Mac s performance on borrower requests on portfolio, warehouse, or securitized pools. PCS Surveillance Workstation provides surveillance capabilities for K-Deal transactions. Document Management System a web-based application supported by IBM to enable electronic imaging of all loan documentation. Resource application that stores and provides access to appraisal data for validation purposes. The company s major development in 2016 has been the successful deployment of a business-to-business portal, which provides seller/servicers a single point of access to exchange information and data with multiple Freddie Mac multifamily applications from within their internal systems. This represents an important advance in efficiency for seller/servicers who can now reduce the need for duplicate data entry. The next integration into the portal planned for 2017 will bring small-balance loan functionality into the application. Also planned for 2017 is a future version of SMART that will maintain CREFC risk ratings for legacy loans. 11

12 A big development in 2015 was the company s transition of its SMART application to an Internet-based platform with full informationtechnology support from its former Access base. Also, version 3.2 of the Consent Request Tracker tool was released in June The company expanded the application to include borrower experience reports, top five request types reports, and aging transfer reports. In addition, it enhanced the Multifamily Securities Investor Access to meet master-servicing obligations and support new transaction types. Also, in 2015, the company released a new version of its property reporting system for using operating statement analysis report templates and implemented associated processes. Finally, the company moved its SMART system to a new technology base for better scalability. This has served to strengthen the asset-management and operations group s surveillance function. In addition, the group enhanced searching capabilities on its Multifamily Maps application, which provides all basic Google Maps data and functionality and has been loaded with loan data from all portfolio and K-Deal securitization loans boarded within the past five years. The application was introduced in 2014 and shows basic and detailed loan-level data with a filter capability allowing the user to query by various characteristics. The application is available on desktops, tablets, and smartphones and can be downloaded to Excel for analysis. Within the multifamily division, each department has its own business-continuity plan containing information needed to recover its business during a disruption. These plans are updated at least annually or as needed and must comply with Freddie Mac s corporate policy. In addition, each department must maintain a documented business impact analysis assessing the potential financial, operational, and reputational impacts to the company s multifamily business resulting from any potential disruption. It must include a projection of recovery time frames and resource allocation necessary to either mitigate risks or support recovery efforts during an event. These are also updated at least annually. Freddie Mac has substantially improved its disaster-recovery and business-resumption capabilities by establishing a data center in Boulder, Colorado, and a hot site in Chicago to relocate key employees in the event of a disaster. Additionally, the company has cross-trained employees at those locations not normally working within asset management and operations to take on specific functions if the group s personnel can t relocate to the sites. In 2014, the company considerably enhanced its recovery time for key functions, most notably processes involving cash, which can now be recovered in four hours while investor-reporting functions can be restored in 48 hours. However, for functions supporting legal transactions or investor reporting for transactions, recovery time could still be up to one week. Furthermore, for internal-facing functions managing the company s balance sheet, portfolio recovery could take between two weeks or longer. The multifamily division completed its outof-region business-continuity plan and its approval authority matrices in The asset-management and operations group backs up data daily and stores data tapes offsite monthly. The company tested the group s Business Continuity Plan in May 2016 with satisfactory results and implemented a regimen of quarterly testing in 2016 as well. Assessment: Freddie Mac continues to build upon important strides to enhance its technology environment initiated in Its development of a business-to-business portal for seller/servicers to have a single point of access to its various multifamily applications from within their own systems tremendously increases efficiencies by eliminating duplicative data entry. Likewise, it greatly improved disaster-recovery and business-continuity capabilities and processes. However, recovery times for non-cash-processing functions remain excessively lengthy and should be curtailed to better protect the company s business in the case of a disruption. Special-Servicing Portfolio Administration As of June 30, 2016, Freddie Mac s total active special-servicing portfolio contained 22 loans with a combined unpaid principal balance of approximately $201.4 million. The portfolio contained one REO property associated with an outstanding UPB of $3.7 million. By comparison, as of Dec. 31, 2015, the company s active special servicing portfolio contained 25 loans with a combined UPB of $259.1 million and one REO property associated with an outstanding UPB of $3.7 million. As of June 30, 2016, Freddie Mac classified only 9% by loan count and 9% by UPB of its active specially serviced loan portfolio as nonperforming. The average loan balance for nonperforming loans was approximately $9.5 12

13 million compared with an approximate $9.2 million average loan balance for all specially serviced loans. The three nonperforming loans ranged in size from $218,000 to $18.8 million. Chart 2 Active Special-Servicing Asset Count by Geographic Concentration* Ohio, 4.3% Oregon, 4.3% Texas, 4.3% Louisiana, 8.7% Alabama, 4.3% New York, 8.7% California, 8.7% Nevada, 13.0% Connecticut, 4.3% Arizona, 8.7% Mississippi, 8.7% Florida, 8.7% Illinois, 4.3% Tennessee, 4.3% North Carolina, 4.3% *As of June 30, Does not total to 100% because of rounding. Asset-Review Process Upon the transfer of a loan to special servicing, asset managers contact borrowers and require them to sign prenegotiation letters before workout discussions. Asset managers prepare asset plans for all loans regardless of size and include a net present value analysis of each possible resolution alternative, when recommended. Both the asset business plans and the NPV calculations are performed on the SMART system. The system also contains guidelines embedded in the application providing checklists for asset managers to ensure all necessary data and analysis for each business plan are complete. Internal guidelines require loan asset managers to complete and submit initial business plans for approval within 90 days of transfer if the loan is in default and 120 days if it is not. REO asset managers must complete and submit initial business plans within 90 days of transfer or becoming an REO. There is no committee approval process, but rather all business plans and REO marketing decisions are approved through a delegated authority matrix. Freddie Mac reported that, on average, it takes one to three business days from transaction closing to deliver fully executed loan modification and restructure documents to corresponding seller/servicers. Assessment: Freddie Mac has proactive and well-controlled asset analysis and recovery practices based on its stated policies and procedures, its approval process, time frames for completing loan and REO resolution plans, and Morningstar s review of selected asset business plans. Furthermore, the asset-management system serves as a highly effective tool to track asset-resolution activities. The company s average time to deliver completed loan modifications to primary and master servicers is exceptional in relation to industry averages. However, the time frames for submitting asset business plans for both loan and REO assets are somewhat lengthy compared with other special servicers. A committee approval process provides the optimal method for reviewing and approving asset business plans. 13

14 REO Property Management Freddie Mac s procedures cover the selection and oversight of property-management companies. The company uses nationally qualified property-management companies, all of which are subject to annual review and recertification. The asset-management and operations group provides each property manager with a standard engagement contract along with its own required policies and procedures manual. This group also maintains strict guidelines for admitting new property managers to its approved vendor list. The property manager s submission package must include the property manager s geographic coverage, relevant experience, assets, properties or units under management, financial statements, policies and procedures, insurance, qualifications and certifications, and past success with Freddie Mac, if applicable. A representative of the asset management and operations special-servicing team visits the regional or corporate headquarters and personally meets with principals of the company and regional managers. In addition, Freddie Mac inspects the property-management company s assets under management as part of the review. Freddie Mac requires three approval levels before adding property-management companies to the approved vendor list. In general, the company s property-management policies require a single trust account for receiving rental income and disbursing operating expenses for REO property management and accounting. The property-management company uploads monthly operating statements electronically to DMS. REO asset managers review property-level operating statements, while separate accounting personnel perform the necessary bank account reconciliations. Policies and procedures delineate the responsibilities of property-management companies and address property preservation projects, which may involve asset managers engaging and overseeing other third-party vendors. Freddie Mac also maintains its own property and liability coverage for REO assets. Having acquired only a few REO properties in recent years, Freddie Mac has not conducted any property-management company audits. Freddie Mac s internal best practices dictate that REO properties be liquidated within nine to 12 months with capital investments made only in the case of life-safety issues or if the expenditure can reasonably be expected to be recouped within 90 days. As of June 30, 2016, Freddie Mac had one REO asset with one property manager in place. During the second half of 2015, the company completed one foreclosure and sold no properties. Assessment: Property management monthly accounting and reporting oversight remains well-controlled. The regimen for vetting and approving new property management companies is extremely thorough and well-documented. The company is conforming to industry best practices by having a team of property accounting professionals assisting asset managers in reconciling property-level operating accounts. Although the volume of REO properties has diminished recently, Freddie Mac has sound REO property-management oversight. Vendor Oversight The company maintains a centralized list of approved vendors for appraisals, engineering and environmental review, property management, brokerage, and legal. Typically, vendors are either drawn from the approved list or recommended by the asset manager after the vendor s submission of a standard application form. The senior director of special servicing approves all recommendations for property-management companies. For appraisal firms, the asset manager works in consultation with governance and business services internal valuation unit. This team, consisting of MAI-certified appraisers, identifies the appropriate appraiser, engages the consultant by written agreement, tracks the completion of the request, and reviews the report for quality before delivery to asset management. Brokers must submit marketing proposals before the company approves them. Responsibility for selecting environmental and engineering firms has shifted to the surveillance unit from 14

15 the former enterprise risk management team. The multifamily division s in-house legal staff controls the engagement process for retaining outside counsel and also reviews all legal invoices for approval and payment. Assessment: Freddie Mac demonstrates sound controls for vendor engagements and oversight. The company s vendor performance tracking process through the asset-management system also strengthens this function. Borrower Consent Requests Freddie Mac has a team of analysts within special servicing to handle borrower consents. In addition, the company uses two third-party vendors for analyzing consent requests, although neither has the authority to make credit decisions for approval. All borrower requests are tracked centrally on its consent request tracker application, a web-based tool that monitors the status of consent requests from borrowers, which are submitted through seller/servicers. The company upgraded this application in 2016 to include a business-to-business portal for seller/servicers to streamline the consent request process. The company has also implemented a more efficient process for property management change requests and streamlined the repair extension approval process by eliminating the loan agreement amendment and servicer acknowledgement of the approval letter. The company recently enhanced the consent request tracker application to include a tracking tool for K-deal representations and warranties. The company maintains a 15-day internal approval timeline for most consents and a 30-day timeline for complex cases. During 2014, the company changed how it tracks the percentage of consent requests completed within those timelines. Whereas in the past Freddie Mac measured completion rates only from the time the consent request reached its offices, the company now measures completion rates from the time the complete borrower consent request package is received by the seller/servicer. The purpose of this change was to achieve a better measurement of the borrower consent-process experience and enable the company to track servicers' performance meeting the servicing standard. While this may well be a useful tool to monitor borrower satisfaction as a whole, it resulted in significantly reduced timeline compliance rates as seller/servicer compliance is ultimately outside of the company s direct control. During the first seven months of 2016, as a special servicer, Freddie Mac handled 2,464 borrower consents, including 347 interest-rate cap requests, 763 repair escrow requests, and 220 property-management changes. The company processed 74% of interest-rate cap requests, 62% of repair escrow consents, and 43% of property-management change requests within required time frames. During 2015, the company administered 3,446 borrower consent requests including 357 interest-rate cap requests, 655 repair escrow requests, and 397 property-management changes. Of these, 78% of interest-rate cap requests, 67% of repair escrow requests, and 39% of property-management change requests were completed within its turnaround timelines. Table 4 Borrower Consent Request Activity January July 2016 Full-Year 2015 Consent Type Processed (#) Total Time (Days)* Processed (#) Total Time (Days)* Repair Escrow Releases Interest Rate Cap Property-Management Changes Total 1,330 1,409 *Maximum time mandated by policies. 15

16 Assessment: The company has sound practices and procedures to analyze and approve borrower consents. Its changes to borrower consent timeline requirements can be effective in assessing the borrower experience and each seller/servicer s compliance with the servicing standard. Managing Conflicts of Interest Freddie Mac is not the named special servicer on its standard K-Deal securitizations, nor does it own any of the first loss or unguaranteed tranches in those transactions. Furthermore, it is not affiliated with property-management, brokerage, or appraisal firms. The company acts as a special servicer only on its owned book of business and for the FREMF 2012-KP01, FREMF 2015-KP02, and FREMF 2016-KP03 transactions (securitizations of loans from its retained portfolio) and FREMF 2015 KVAD and FREMF 2016-KIR1 transactions (single-sponsor securitizations). Assessment: Freddie Mac has no discernible conflicts of interests, such as those that may appear with other special servicers that may hold interests in lower-rated tranches of a security and/or use affiliates for property managers, brokers, or valuation providers. Asset-Resolution and Recovery Performance During the first half of 2016, Freddie Mac received 11 loans for special servicing totaling approximately $99.2 million in UPB (with an average loan balance of $9.0 million) and resolved eight loans representing approximately $108.7 million in UPB (average balance of $13.6 million), of which five loans totaling $58.2 million were full payoffs and three loans totaling $50.5 million were restructures or modifications. The company managed one REO property associated with a UPB of $3.7 million. By comparison, during the second half of 2015, the company received eight loans for special servicing representing approximately $123.1 million in UPB (average balance of $15.4 million) and resolved eight loans with a UPB of approximately $110.6 million, all of which were full payoffs. 16