Fannie and Freddie Are Right to Force Bad Mortgages Back to Banks

Fannie Mae and Freddie Mac are poised to push $21 billion in troubled mortgages back to the banks who originated them. Bloomberg reports that this could result in losses up to $7 billion, according to an Oppenheimer & Co. estimate. While I'm generally pretty critical of Fannie and Freddie, this move is justified and utterly sensible.

While this is a very sizable pool of mortgages, the action isn't unprecedented. Last year, banks incurred about $5 billion in losses from what Fannie and Freddie put back to them. Bloomberg explains why these mortgages are being forced back to the banks:

Banks that sell mortgages to Fannie Mae and Freddie Mac have to provide "representations and warranties" assuring that the loans conformed to the agencies' standards. With more loans going bad, the agencies are demanding that banks turn over loan files, so they can scour the records for missing documentation, inaccurate data and fraud.

The most common include inflated appraisals or falsely stated incomes in the loan applications, said Larry Platt, a Washington-based partner at law firm K&L Gates LLP who specializes in mortgage-purchase agreements. The government agencies hire their own reviewers who go back and compare the appraisals with prices from historical home sales, he said.

Basically, banks sometimes sell Fannie and Freddie mortgages that didn't conform to the standards necessary for their purchase. When the agencies realize this, they can retroactively refuse the sale or guarantee. And they should: either banks accepted fraudulent information, did lax due diligence or failed to obtain the necessary documentation. The agencies shouldn't be paying for banks' negligence.

Since taxpayers now own Fannie and Freddie, it's more important than ever that they not accept loans that never conformed to their standards. After all, their losses are high enough for the loans that did conform without having to incur more from loans that they never should have purchased in the first place. While it's bad for banks, lower losses for Fannie and Freddie means fewer taxpayer dollars needed to prop up the agencies.

Of course, this does raise an interesting question: why don't the agencies take a little more time to ensure that loans actually do conform before taking them on? In fact, the process is quite quick for banks to get loans funded. Clearly, it's a little too quick. There must be times when nonconforming loans slip through, undetected by the agencies even after losses have been declared -- this $21 billion are just those they caught. And $21 billion dollars of mortgages isn't exactly negligible. More rigorous conformity verification should be sought to prevent these loans from getting through in the first place.