A new Bloomberg article out today on the topic of the mortgage repurchase fiasco is a treasure trove of insight into the current state of affairs between Fannie Mae and Freddie Mac on the one hand and the big banks on the other. First, the big picture.
Here's the upshot of the story: Banks are starting to push back against Fannie and Freddie on loan repurchases. According to the Bloomberg article, "Lenders say they are resisting buybacks because McLean, Virginia-based Freddie Mac and Washington- based Fannie Mae are unfairly second-guessing old appraisals, accusing originators of failing to verify income, or pinning failed loans on minor technical errors."
Perhaps I'm missing something.
Are the lenders asserting that the three points listed above are not relevant in evaluating the validity of a loan repurchase? Think about each in turn: 1) the value of the underlying asset being purchased with the loan; 2) the credit worthiness of the borrower; and 3) the lender's ability to document and verify the information attested to in the loan documentation.
Now, let's engage in a little thought experiment. Imagine you are an employee of Fannie Mae or Freddie Mac. In fact, you are one of the guys or gals responsible for buying loan portfolios and mortgage-backed securities, which have been built from a loan portfolios. It's your responsibility to understand the products you buy—and to understand the risks and consequences of holding them.
Because remember: Your shop—Fannie Mae or Freddie Mac—is issuing its own agency debt. And the bondholders of that agency debt expect to get paid—no matter what. In fact, pension funds and other large institutional investors historically treated agency debt nearly like U.S. Treasury securities. So there is kind of a lot of pressure on you to make sure that the mortgages and mortgage-backed securities that you're buying are credit worthy. Because the securities you buy from banks are what generates the cash flow to service the debt your agency issues.
And the broader point is this: Fannie and Freddie are responsible to their creditors whether the loans they bought perform or not.
So what happens if the cash flows that Fannie and Freddie relied upon to back the debt collapse?
Well, it's a little bit like Henry Hill describes in the movie Goodfellas : "Business bad? F**k you, pay me. Oh, you had a fire? F**k you, pay me. Place got hit by lightning, huh? F**k you, pay me." Those are your repayment imperatives when big Paulie is your business partner—and it's kind of the same way when you're the one on the hook to make payments on agency debt.
So, as the person responsible for buying securities from banks, you tend to be pretty careful about the things you buy.
But you do have one major point in your favor. Because of the critical role these loans and securities play in supporting agency debt, there are repurchase agreements in place to protect Fannie and Freddie. In other words, if you buy a security that turns out to be something other than what it was represented to be you can make the bank buy it back from your agency.
So you feel pretty good about making these purchases on the agency's behalf. You've got good agreements in place. Besides, the bankers have assured you: All material representations about the loans you are buying are covered under the terms of the warranties. So far so good. But now, a couple of years later, the default rates on the loans you bought begin to skyrocket.
That makes you a little nervous—because after all you’re the person who bought the stuff. So you ask people at your agency to start looking into the warranties and representations on the loans that you purchased.
It turns out—and I'll phrase this as objectively as possible—that some of the representations that were made to you appear to be inconsistent with the associated loan documentation.
It's reasonable to expect that you might be pretty steamed—especially if you're catching heat for default rates that are far higher than you anticipated, based on representations that were made to you at the time of purchase.
So what you do with the bad loans? The odds are pretty good that you're going to demand that the bank who sold them to you in the first place repurchase them. After all, that was the purpose of the warranty.
And demand Fannie and Freddie do. But it's a slow process. In fact, the story doesn't even start to heat upuntil long after the default rates start to escalate.
Which brings us to this morning's article.
Despite all the travails you've experienced in your role at Fannie or Freddie, you remain at your job—still purchasing loans from banks on behalf of the agency, embattled though the process may be.
When you arrive at your desk, you see the Bloomberg article.
Then you read the excerpt quoted above—about how your agency is "Unfairly second-guessing old appraisals, accusing originators of failing to verify income, or pinning failed loans on minor technical errors".
What can you do but shake your head? Or search for a new career.
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