Banking Law

The country's largest commercial banks have become the largest originators of residential mortgage loans. Unfortunately for them, they're also becoming the recipients of knuckle massages lovingly administered by those "instruments of public policy," Fannie Mae and Freddie Mac. As we've long noted, the major risk in being a mortgage originator and seller is the risk of the buyer doing everything it can when default rates rise to force the seller to buy back the loans that don't perform well. According to The Wall Street Journal, Fannie and Freddie, who now account for 70% of the market for residential mortgage loan purchases, are doing precisely that.

It is payback time for Fannie Mae and Freddie Mac on some mortgages sold to the finance companies by lenders.

Stuck with about $300 billion in loans to borrowers at least 90 days behind on payments, Fannie and Freddie have unleashed armies of auditors and other employees to sift through mortgage files for proof of underwriting flaws. The two mortgage-finance companies are flexing their muscles to force banks to repurchase loans found to contain improper documentation about a borrower's income or outright lies.

The result: Freddie Mac required lenders to buy back $2.7 billion of loans in the first nine months of 2009, a 125% jump from $1.2 billion a year earlier. Fannie Mae won't disclose its figure, but trade publication Inside Mortgage Finance said Fannie made $4.3 billion in loan-repurchase requests in the first nine months of 2009.

Community bankers have watched the big banks dominate the residential mortgage origination business, especially following the collapse of the large independent mortgage originators over the last few years. It's very difficult for community banks to compete with the large boys in a business where profit margins are thin and compliance and technology investments can be heavy. Therefore, it brings a little tear of joy to the corner of the eye of many small bankers when they see who's taking it on the chin from the punches thrown by Uncle Freddie and Aunt Fannie.

The biggest losers are likely to be Bank of America Corp., J.P. Morgan Chase & Co. and other mortgage lenders when the housing bubble burst. Such lenders also are being deluged with loans kicked back to them by holders of mortgage-backed securities who uncover deficiencies with loans bundled into the pools. One common example: a borrower who said the loan was for an owner-occupied home but used it for a second house.

Overall, banks repurchased about $14.2 billion in loans from holders of mortgage-backed securities in the first nine months of last year, up from $3.6 billion a year earlier, according to Barclays Capital. The figures are based on data reported to regulators by federally insured banks and savings institutions.

Forced loan buybacks threaten to "wipe out a significant portion of the [loan] origination profits?made in the last year," said Nicholas Strand, a Barclays analyst.

I went through this on a much milder scale for a large client that bought the large servicing platform and a bundle of servicing rights from the RTC. The platform and servicing rights had previously belonged to a large savings bank that had bitten the dust in the early 1990s. Unlike a private seller, the RTC sold servicing rights without the ability to put them back if there were defaults under Fannie Mae's or Freddie Mac's seller/servicer guides prior to the date of sale. When problems later cropped up with loans in the portfolio, which, as might be expected, arose when borrowers started defaulting, Fannie and Freddie looked to the current servicer (my client) and told it to buy the loans back. In a perfect world, the current servicer then passes the loan back down the line until it reaches the originator. When my client turned around to pass off the loans, it was looking in the mirror. It's tough being the last solvent man standing when the repurchase arrows start flying. You better hope the relatively cheap price you paid the RTC makes up for the fact that you're stuck in the mud with no way out.

Today, the problem is much, much worse.

Fannie reported Thursday that borrowers of 5.29% of the loans it guarantees were at least 90 days behind as of November, up from 2.13% a year earlier. Fannie guarantees $2.9 trillion in loans.

At Freddie, such delinquencies reached 3.87% at the end of December, up from 1.72% a year earlier.

While growth in subprime defaults is slowing, defaults on prime loans are accelerating. Such loans account for 90% of all mortgages guaranteed by Fannie and Freddie.

"Delinquency rates are up, so it's not surprising" that buyback demands are up, said Brad German, a Freddie Mac spokesman. "Consequently, the number of loan put-backs will reflect that."

As an American taxpayer, I can't say I'm displeased that the two publicly-owned mortgage securitizers are scouring loan files looking for ways to lower their losses. Then again, I don't own stock in Bank of America, J.P.Morgan Chase, or Wells Fargo. If I did, I wouldn't be quite so sanguine.