Insight: Fannie Mae, Freddie Mac clamping down on banks

The government-controlled companies are squabbling with banks over who should bear the burden of losses from the housing crunch, in particular loans made between 2005 and 2008, when the market was at its frothiest.

Fannie Mae and Freddie Mac's efforts will translate to higher mortgage losses for banks in the coming quarters. But the end of the fighting may be in sight. Fannie Mae, the larger of the two finance companies, is more than halfway through its review of loans to try to sell back to banks and is mainly focusing on that four-year period, a source familiar with the matter said.

Fannie Mae and Freddie Mac buy mortgages from banks and bundle the loans into bonds that get sold to investors. The loans are supposed to have met guidelines to be eligible for bundling. The two mortgage giants guarantee the packaged bonds.

Historically, Fannie Mae and Freddie Mac have taken banks at their word when they said loans were eligible. If later there were problems (because the borrower's income was not properly verified, for example), then Fannie Mae and Freddie Mac could ask banks to buy back the mortgages at face value and absorb any losses.

Those repurchase requests are increasing as Fannie and Freddie apply more scrutiny. Both companies have hired more staff to comb through loans and determine which can be sold back to banks.

In the second quarter, outstanding repurchase requests at Fannie Mae grew by 20 percent to $14.6 billion from the first quarter, according to a filing last week.

Banks can argue about whether they really did follow guidelines, but the impact of buyback requests on lenders is clear. Bank of America Corp, Wells Fargo & Co, PNC Financial Services Group Inc and others set aside more money in the second quarter to cover repurchase requests.

Fannie Mae and Freddie Mac say they are trying to recover as much money as possible for taxpayers after receiving more than $188 billion of government support during the housing crunch. They have since repaid about $45 billion.

Banks believe Fannie and Freddie are nailing them on technicalities. If the two companies bear down too hard on lenders, banks could originate fewer mortgages, further pressuring the housing market.

That may already be happening. Bank of America has reduced its mortgage lending and is no longer selling most loans to Fannie Mae. And Fannie Mae and Freddie Mac's regulator is concerned enough that it is thinking of changing the repurchase process to press the companies to look at loans before agreeing to guarantee or purchase them.

A suffering housing market hurts Fannie Mae and Freddie Mac as well.

"It's an interesting legal dance and business relationship dance that Fannie and Freddie are playing," said Joseph Buonanno, a lawyer at Hunton & Williams who specializes in mortgage and capital markets issues.

NUMBERS SWELLING

In addition to repurchase requests from Fannie and Freddie, the banks also face possible losses from loans sold to private investors and those that were insured by bond insurers, who say they shouldn't be on the hook for inappropriately underwritten loans.

Generally, banks' disputes with Fannie Mae and Freddie Mac have to be worked out loan by loan. The government-owned companies' efforts to craft broad settlements with banks, most notably Freddie Mac's deal with Bank of America announced in January 2011, have come under criticism.

The inspector general at the Federal Housing Finance Agency, which regulates Fannie Mae and Freddie Mac, said there were questions about how Freddie came up with its settlement figure, which may have cost taxpayers billions of dollars.

Since then, Freddie Mac has not entered into any new agreements. This year it started reviewing more loans for possible defects, which "may result in higher repurchase requests," according to a quarterly securities filing.

Fannie Mae in January 2011 also reached a settlement with Bank of America, but it only covered Countrywide-related repurchase requests that were in the works as of September 2010. Bank of America bought subprime lender Countrywide Financial in 2008.

In recent securities filings and earnings conference calls, Bank of America complained about the repurchase demands: Many requests came for loans that were fine for at least two years before going bad.

The bank said the borrowers' ability to make payments for that length of time shows the loans went bad because the economy went south and not because of the quality of the underwriting.

But Fannie Mae and Freddie Mac say if the banks failed to meet the guidelines, they have no case. Underwriting guidelines are an important protection since banks make loans but Fannie Mae and Freddie Mac take the credit risk.

In its filing, Fannie Mae said more than 2 percent of loans acquired between 2005 and 2008 resulted in bank repurchase requests, compared to less than 0.25 percent of loans acquired after 2008.

Freddie Mac had outstanding repurchase requests of $2.9 billion at the end of June, down from $3.2 billion at the end of March but up from $2.7 billion at the end of December, according to its latest quarterly filing.

MORE COMING

Bank of America wasn't the only bank to see an increase in repurchase requests. In a report last week, Bernstein Research analyst John McDonald said unresolved claims with Fannie and Freddie rose to $17.3 billion from $14.3 billion at seven banks he covers, reflecting a rise in demand and slower resolution of existing claims.

Fifth Third Bancorp said last month that Fannie and Freddie have indicated that toward the end of the year they plan to start requesting loan files for any loan that is not performing. Requests for files are a precursor to making a repurchase request.

PNC has also noted requests for more loans that performed for a significant amount of time. US Bancorp has said Fannie and Freddie have increased their loan sampling sizes.

Fannie Mae spokesman Andrew Wilson said the agency is enforcing its contracts and treats all lenders consistently.

"Fannie Mae has not changed its criteria for evaluating loans for potential repurchase. What changed was the volume of loans from 2005-2008 that did not meet our standards and therefore must be repurchased by lenders," he said.

Freddie Mac emphasized that it works with lenders and gives them time, for example, to find missing documents. Lenders are nevertheless required to honor their contracts, said spokesman Michael Cosgrove.

"We have an obligation to taxpayers to be good stewards of their investment," he said.

In his research note, McDonald said he believes the cost of repurchase requests will be manageable for banks but are likely to be a drag on earnings and companies' net worth, or book value, for 2012 and 2013.

Housing Finance Agency is expected to announce new repurchase request standards for new loans by September. In a letter to Congress last month, acting director Ed DeMarco said the agency is developing requirements that would shift the review of loan sales to the time of the sale and give lenders more certainty that they won't have to buy back loans that have performed successfully for a period of time.

"While this will result in greater scrutiny of performing loans near the time of origination, the intent is to reduce the risk for the Enterprises and lenders alike," DeMarco wrote in the July 31 letter.

(Reporting by Rick Rothacker in Charlotte, North Carolina; Editing by Dan Wilchins and Prudence Crowther)