What a difference 18 months can make.
Need an example?
Look no further than recent news from the GSEs that lenders are thumbing their noses at repurchase and reimbursement requests in record numbers.
As reported in their quarterly filings, Fannie Mae and Freddie Mac are seeing an increase in the number of lenders not honoring agreements to repurchase loans that breached representations about the eligibility and quality of loans they sold.
While this is not uncommon in the current economic environment, there is noticeable difference: Lenders have told us that the GSE’s are showing real stamina and commitment to auditing non-performing loans, and a new toughness towards collecting on repurchase demands.
Contrary to what many have feared or “heard,” the GSEs generally try to avoid issuing repurchase demands for subjective issues, or compliance issues, and focus on material misrepresentations or omissions. It’s very likely that the GSEs would tell lenders that 90% of repurchase requests are because their AUS findings and requirements were not followed and/or properly underwritten or documented by the lender. Improperly calculated or inconsistent income, unverified assets, and undisclosed debts are the major culprits. While bad appraisals and fraud are legitimate triggers for repurchase demands they are far less likely to be the primary reason because of their subjective nature.
During the heady times of 2003-2007 lenders were far more focused on velocity on loans then they were on the quality of the loans. As volume continued to spike the rating agencies, secondary market investors, and regulators got more and more comfortable with “certifications” and “representations.”
As an industry, we have always had the difficult task of measuring the return on investment in areas related to loan quality vs. loan marketing and origination. It was easy to see the return on hiring one more loan officer or sending out one more marketing piece, but how do I justify another quality assurance person?!?! Isn’t that going to slow things down and cost us more money in the long run? We need to feed the beast – grow market share! As a result, we all know where the investments were made. And market competition and lax oversight moved us from the model of “trusting and verifying” to simply “trusting.”
Understanding the problem and its genesis is only part of the story. What about the enforcement of repurchase demands? 18 Months ago, the GSEs could be a little light handed in their enforcement of repurchase demands because they didn’t want to risk losing a lender’s loan production and delivery business. Frankly, they didn’t want to lose a lender to the competing GSE. There were times when substantial repurchase demands would go unpaid (not forgiven) as a concession to large lenders when it came time to negotiate their delivery contracts.
That was then, this is now. The GSEs now have no choice but to get as strict as possible in enforcing these agreements. Many lenders think the GSEs will simply settle for pennies on the dollar as customary in today’s market when buying and selling mortgage and real estate assets. But think about the unintended consequences of the GSEs settling for a fraction of what they are contractually owed. Say the GSEs took 90 cents on the dollar as a settlement for the repurchase demands made to a lender. Will that lender, and the industry for that matter, due more or less due diligence on loans that they can sell for 103bps and in the off chance the loan underperforms and is audited that they can buy it back for only 90% of the note amount. Not a great precedent.
Financial institutions in particular have one large and legitimate grievance. For as long as the GSEs have been issuing preferred shares bank regulators have treated the assets as riskless as Treasury bonds. Therefore, banks made an economic decision to hold the preferred shares as TIER 1 capital since they were higher yielding and seemingly had the full faith and credit of the United States (why else would regulators require the same amount of capital against them as Treasuries?) With those preferred shares virtually worthless, lenders are naturally less sympathetic to the demands made by the GSEs to make them whole on their losses.
The enigmatic part of the equations is that as private enterprises the GSEs could make the business decision to settle their claims with lenders to improve capital positions and cash flows. But there’s a catch. Today, the Treasury essentially owns all or partial interest in both GSEs as well as in many of the entities (banks) requiring to repurchase the non performing loans. Compensation and penalties enforced by one entity now cause offsetting penalties or compensation to the other. Either way the Treasury comes out on the short end of the deal.
I would not expect the pattern or volume of audits and repurchase demands to slow or change in 2010. It is very likely to get worse before it gets better for lenders as the GSEs work through the backlog of NPL files they currently have and prepare for new ones. Lenders and investors need to get better at originating loans with built in quality vs. our tendency to inspect in quality after a loan has closed.
Regrettably, this is just one example that we’re in for a long haul in our way out of the housing crisis and into a restructured primary and secondary mortgage market.
Tim Rood is a managing director of the Collingwood Group. In his two decades of mortgage industry experience Tim co-founded Capital Financial Solutions, was Vice President at First American, and served as Senior Director and Principal of Fannie Mae’s eBusiness Division.