While at Fannie Mae, I was struck by bankers' fears that they would need to buy back loans from the government-sponsored enterprises, not just during the crisis but also just a few months ago, before I left the company. The good news for banks is that fear isn't justified based on what the GSEs have seen in actual repurchases.
True, there were plenty of repurchases across the industry during and following the Great Recession, but understanding why that occurred and why repurchase concerns have eased should help increase confidence in lending.
When a loan is sold to Fannie or Freddie Mac — which are widely known as housing "agencies" — the originator represents and warrants that the loan meets the respective GSE's eligibility and underwriting guidelines. This "reps and warranties" obligation is necessary because the agencies do not review loan files prior to purchase. If the loans are later found to be ineligible or defective, the agencies will require a repurchase or "put-back" to the lender.
The crisis-era repurchases accelerated as Fannie and Freddie identified a correlation between defaults and underwriting defects in originating loans that were found to have violated the agencies' requirements.
But since then, dare I say, the industry has changed dramatically. The number of repurchases is way down. In a recent filing, Fannie reported that it had issued repurchase requests on a sparse 0.26% of the more than $470 billion in unpaid principal balance of single-family loans acquired in the 12 months ending in September 2015. And a Freddie executive recently posted on the company's website that completed repurchases had "dropped from a peak of $4.2 billion in 2010 to about $400 million in 2015, a 95 percent drop."
Even when repurchase requests are high, a fairly large percentage of those requests are resolved without a repurchase. This is because either the lender provided additional documentation satisfying agency requirements, or the lender accepted a repurchase alternative.
But requests are down too, due in no small part to improvements in the credit environment and more prudent lending practices. Yet lenders may not be aware of other developments that should ease their repurchase worries. Here's a rundown of what's changed:
- Changes in Fannie and Freddie's underwriting standards as a result of what they learned in the credit crisis are helping to ensure that higher-quality loans are sold on the secondary market.
- The industry has adopted loan quality standards established during and after the crisis, which are more effective at detecting errors before the loans are closed. Both agencies require lenders to have detailed policies for detecting errors in loan quality, and make efforts to verify that lenders are following those policies. Lenders tell me that these standards are working, because defects are down.
- Most loans are subject to the Consumer Financial Protection Bureau's regulations requiring lenders to fully document the borrower's ability to repay the loan.
- Modern technology tools are helping lenders to detect defects sooner. Both the agencies offer lenders state-of-the-art underwriting software engines which help ensure loans meet underwriting standards. The GSEs also offer lenders early delivery-edit checking software. Lenders tell me they run each loan through this software several times before they close the loan and use this data to analyze ways to improve performance throughout the manufacturing process.
- Fannie and Freddie have also developed new appraisal review software tools. Fannie's software identifies appraisal defects and provides lenders with a wealth of information on each property. Freddie's version of this tool is about to be released.
Perhaps most important, the Federal Housing Finance Agency has changed the representation and warranty framework. The new framework, effective for conventional loans sold or delivered since January 2013 (and updated several times since then), now limits the duration of underwriting risk on loans delivered to the agencies.
During the credit crisis, the industry raised concerns about life of loan reps/warranties that can result in a put-back years after a loan was originated, even if the loan paid on time for three or more years. That has all changed and now there are sunset provisions that eliminate most of the rep/warrant risk 36 months after delivery. Millions of loans sold to Fannie Mae and Freddie Mac have now passed the sunset on underwriting defects.
What does this mean? If a loan defaults after three years of on-time payments, in most cases, the lender will not be subject to a repurchase demand. There are some exclusions, but these are somewhat extraordinary, like title defects or loans where mortgage insurance was required and never obtained.
Repurchase requests have not been entirely eliminated, and your bank should always carefully review any file for which a repurchase request is made. But a repurchase demand doesn't mean a buyback is a foregone conclusion. When Fannie and Freddie send a repurchase letter, many of those requests provide an alternative fee-based option which eliminates the repurchase. The lender always has the option to pay the fee or repurchase the loan.
It is true that repurchases across the industry during and just following the Great Recession led to consistent worry. But understanding why that occurred and why repurchase concerns have eased should help increase confidence in lending.
Jennifer Whip is managing director at Garrett, McAuley & Co. Previously she was the primary executive at Fannie Mae responsible for business development in the single-family division.