Freddie May Have Spared Banks, Cost Taxpayers, Watchdog Says

Freddie Mac is reviewing its procedures for examining mortgages after auditors faulted its handling of lapsed loans issued before the 2008 credit crisis, a government watchdog said in a report on the finance firm.

The mortgage-finance firm, which is operating under U.S. conservatorship, didn’t do enough to find flaws that could’ve increased recovery of money from banks that sold defective loans, the Federal Housing Finance Agency’s inspector general said in the report released today.

FHFA, the regulator that oversees Freddie Mac and larger rival Fannie Mae, suspended loan-repurchase agreements while the agency and the McLean, Virginia-based company explore ways to uncover more defective loans, according to the report.

“It is critical that this issue be resolved, as it involves potentially considerable recoveries for Freddie Mac and ultimately taxpayers,” the inspector general’s office said in the report.

FHFA examiners and Freddie Mac’s own auditors flagged problems with the loan-review process early last year. They told executives and board members that reviewing a larger sample of loans could increase recovery under agreements banks signed with Freddie Mac, which has been under U.S. control since it was seized along with Washington-based Fannie Mae in 2008.

Freddie Mac signed a $1.35 billion settlement with Bank of America Corp. (BAC) in December, with the FHFA’s consent. The agreement, which resolved past, present and future repurchase demands on 787,000 loans, was based on the company’s flawed review process, the report found. Fannie Mae reached its own $1.52 billion settlement with Bank of America.

Conservatorship

Freddie Mac and Fannie Mae, firms created by Congress to boost homeownership, were placed under conservatorship in September 2008 after defaults stemming from the collapse of the subprime mortgage market pushed them to the brink of collapse. Since then, they have drawn more than $170 billion in taxpayer aid to remain solvent.

The two firms provide liquidity to the mortgage market by buying bundled loans from banks under terms that require repurchase of those that prove defective. At the end of June, Freddie Mac had $3.1 billion in repurchase demands outstanding.

The FHFA sued 17 lenders this month on behalf of Fannie Mae and Freddie Mac, citing possible defects in $196 billion worth of mortgage securities owned by the companies.

Surface Quickly

When long-term, fixed-rate loans dominated the market, mortgage defaults tended to occur within three years of a loan being issued. Based on that experience, Freddie Mac expected defective mortgages to surface quickly and spent little time reviewing older loans.

“Rather than foreclosures declining over time, Freddie Mac-supplied housing data revealed foreclosures increasing, three, four and five years after purchase,” the inspector general found.

An FHFA examiner raised concerns about the changing pattern in March 2010, noting that Freddie Mac had reviewed less than 10 percent of failed 2005 and 2006 loans, thus “eliminating any chance to put ineligible loans back to the lenders from those years” and potentially costing the company billions of dollars, the report found.

Freddie Mac resisted calls to conduct more testing of older loans. At a July 2010 meeting, a Freddie Mac manager told regulators that loan reviews were “resource constrained” and sampling older loans was “not the highest and best use” of the company’s limited resources.

‘Business Relationships’

Freddie Mac managers also worried that aggressive loan reviews and increased repurchase demands “would adversely affect Freddie Mac’s business relationships with Bank of America and other large loan sellers” and cost the company business, the inspector general reported.

In a September 2010 e-mail to agency officials, an FHFA examiner said “Freddie Mac could be passively absorbing billions of dollars of losses.”

Freddie Mac’s board approved the Bank of America settlement on Dec. 14. Two weeks later, FHFA Acting Director Edward J. DeMarco signed off on the deal.

“By relying on Freddie Mac’s analysis of the settlement without testing the assumptions underlying Freddie Mac’s existing loan review process, FHFA senior managers may have inaccurately estimated the risk of loss to Freddie Mac,” the inspector general reported.

To contact the reporter on this story: Lorraine Woellert in Washington at lwoellert@bloomberg.net

To contact the editor responsible for this story: Lawrence Roberts at lroberts13@bloomberg.net

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