A U.S. flag decorates a for-sale sign at a home in the Capitol Hill neighborhood of Washington, in this August 21, 2012, file photo.Jonathan Ernst/Reuters
Just four years after toxic U.S. mortgages brought the global financial system to its knees and triggered the deepest recession since the Great Depression, a U.S. housing regulator may be making it easier for banks to make bad loans without suffering losses.
The Federal Housing Finance Agency released a little-noticed rule week before last that makes it harder for Fannie Mae and Freddie Mac – the government-owned companies that guarantee home loans made by banks – to hold lenders accountable when mortgages go bad.
Some experts said the new rules show that lessons of the housing crisis are already being forgotten, and could set up taxpayers for tens of billions of dollars of losses if the lending bubble re-inflates later in the credit cycle.
At issue is when Fannie Mae and Freddie Mac can press banks to make them whole when mortgages go bad.
Under the current rules, the two U.S. government-backed companies can push banks to buy back mortgages that were fraudulent, or not properly underwritten.
Under the new regulations, starting with loans sold to Fannie Mae and Freddie Mac in January, if the borrower makes payments for 36 consecutive months, banks cannot be asked to buy them back due to underwriting or appraisal problems. So if the borrower did not have enough income to qualify for a loan to begin with but Fannie Mae or Freddie Mac did not notice for three years, the bank could not be pressed to buy back the loan.
For new loans, the bank can still be pushed to buy back the loan for reasons such as fraud or errors in submitting data. The new rules do not apply to existing loans.
The upshot of the rules is that Fannie Mae and Freddie Mac must check more loans early in their lives to avoid problems later.
"These regulations assume we'll never get another mortgage crisis," said Joseph Mason, a professor at Louisiana State University's business school who specializes in structured finance.
If there is another mortgage crisis, Fannie Mae and Freddie Mac could lose even more than they did this time around, he added.
A former senior executive at one of the two companies also found the regulations nettlesome.
"It's easier for banks to give you (Fannie Mae or Freddie Mac) bad loans with these new rules," he said.
Just how many repurchase requests result from underwriting problems is unclear. The FHFA last week said that past repurchase requests issued by Fannie Mae and Freddie Mac were triggered by "substantive underwriting and documentation deficiencies," but the agency declined to provide details.
Fannie Mae and Freddie Mac currently have about $17.5-billion (U.S.) of repurchase requests outstanding, which they attribute largely to loans made at the height of the housing bubble from 2005 to 2008. The two companies are still making requests for banks to buy them back, and the requests take time to resolve.
The FHFA, which regulates Fannie Mae and Freddie Mac, believes lending has contracted too much and has said it's trying to encourage home loans by giving banks more certainty about when they will have to buy back soured loans that they sold to the two finance companies.
The regulator has told Fannie Mae and Freddie Mac explicitly to fix the process of selling back bad mortgages in a way that will encourage lending, a senior official at one of the two companies said.
The official, who requested anonymity because he was not authorized to speak to the media, acknowledged the potential for shenanigans under the new rules.
"People can work surprisingly hard at not following the rules. It certainly is a risk," he said.
Maria Fernandez, the FHFA's associate director for housing and regulatory policy, said the new rules leave ample protections for taxpayers. She stressed that banks are still on the hook to deliver high-quality loans, and are still responsible for fraud and data-entry errors.
"Our intent," she added, "certainly is not to increase the risk exposure to Fannie Mae or Freddie Mac or the taxpayer."
The new rules show how conflicting agendas and policy imperatives are making it hard to fix the housing sector.
Fannie Mae and Freddie Mac collapsed in September, 2008, as investors grew nervous about the companies' low capital, high debt, and rising losses from bad home loans. The government rescued them and still backs them. The two companies have already drawn a total of $188-billion in taxpayer funds to stay afloat. While they have earned money in recent quarters, it's still unclear when they will fully reimburse taxpayers.
The FHFA, which was created in 2008 to regulate Fannie Mae, Freddie Mac, and the Federal Home Loan Banking system have conflicting mandates. The regulator is supposed to ensure that credit flows to the housing market, but is also expected to ensure that the government-backed companies are stable, which can sometimes mean cutting off credit to borrowers.
At a time when the housing market is still recovering, the agency is faced with a tough choice – relax rules to encourage banks to lend more, potentially creating new losses in the future, or keep regulations tight and face accusations of constraining the housing market and the broader economy.
To be sure, any potential losses are at least several years away and the future of Fannie Mae and Freddie Mac is an open question– President Barack Obama has said he wants to wind them down. Meanwhile, the housing market could do with more lending. Even though owning a home is cheaper than renting in the 100 biggest U.S. cities, credit is so tight that many people cannot benefit.
A Federal Reserve analysis released Tuesday said that lenders made 7.1 million mortgage loans in 2011, the lowest annual number since 1995.
The Fed is making a conscious effort to boost the money supply and reduce the jobless rate by buying large quantities of mortgage bonds – up to $40-billion a month for as long as necessary. Chairman Ben Bernanke called housing "a missing piston" in the U.S. recovery when announcing the policy last week.
Bernanke said the new FHFA rules, which were issued Sept. 11, should also help the market.
The current rules are saving Fannie Mae and Freddie Mac billions of dollars.
The two companies have $11-billion of outstanding requests to Bank of America Corp. alone to buy back bad mortgages. In a sign of how borrowers can make payments on even flawed loans, nearly $8-billion of these mortgages performed well for at least two years, until they went bad and Fannie Mae and Freddie Mac scrutinized them carefully.
The inspector general for the FHFA said in a report on Sept. 13 that last year after Freddie Mac started looking at loans that had defaulted after at least two years of payments, it will now collect up to $3.4-billion more on repurchase requests.
Fannie Mae and Freddie Mac could have an easier time monitoring loans as they come in thanks to efforts from the industry and regulators to digitize more mortgage information, FHFA's Ms. Fernandez said.
Under an initiative called the Uniform Mortgage Data Program, lenders are now providing Fannie Mae and Freddie Mac with appraisal and other data in an electronic format, allowing quicker and easier analysis, she said.
It's unclear how much of a boost the new rules will give to the flow of credit. In a report this week, FBR Capital Markets analyst Paul Miller said officials at JPMorgan Chase & Co. have said they will make little difference, while Wells Fargo & Co. executives have said they will give lenders more confidence in making loans with lower credit scores.
"We believe that the guidelines will be helpful on the margin but are not enough to make lenders comfortable lending to lower (credit score) borrowers," Mr. Miller wrote.
Many experts on Fannie Mae and Freddie Mac were also skeptical of the companies' ability to monitor the hundreds of thousands of loans that get made annually. Banks will likely find loopholes in any electronic monitoring the agencies perform, said the former senior official at one of the companies who declined to be named.
"Even with the best controls in the world, you won't catch this stuff," he said. It is always difficult for outsiders to assess the quality of Fannie Mae's and Freddie Mac's controls, he added.
If loan volume goes up, Fannie Mae and Freddie Mac will also have to spend a lot of money to maintain strong quality assurance programs, said Edward Pinto, a former Fannie Mae chief credit officer who is now a resident fellow at the American Enterprise Institute think tank. In boom times, quality assurance isn't always a top priority, he added.
"The intention is, 'We will build this robust quality assurance,' and then all of sudden the business starts coming in over the gunwales," Mr. Pinto said.