Two FHFA Announcements to Kick-Off the MBA Conference: One Very Reasonable and the Other an Unnecessary Risk

On Monday, October 28, 2024, as the Mortgage Bankers Association (MBA) Annual Conference kicked off, the Federal Housing Finance Agency (FHFA) introduced two significant updates impacting mortgage lenders, one innocuous and the other double-edged. The first policy change requires Fannie Mae and Freddie Mac to give lenders 60 days’ advance notice of any increase in base guarantee fees above one basis point for loans delivered through the mortgage-backed security swap channel, which allows banks to receive MBS in exchange for mortgages (This is beneficial for lenders because while they have to hold capital for loans they keep on their books, MBS count as collateral; if this sounds problematic, you are not wrong). This notification policy offers lenders greater predictability in their cost structures, aligning with the FHFA’s broader goal of stabilizing the mortgage market.

The second, and more controversial, announcement extends Freddie Mac’s fee-based repurchase alternative for performing loans with minor defects to all approved lenders, following a limited pilot that began in early 2023. This approach allows lenders to pay a fee based on defect rates rather than shouldering the full expense of repurchasing loans within the first 36 months after origination. In a traditional repurchase, a lender must buy back loans that fail to meet underwriting standards, shifting the financial risk back to the lender and often straining liquidity. According to Naa Awaa Tagoe, FHFA’s Deputy Director of Housing Mission and Goals, the fee-based model offers a more manageable and predictable alternative by calculating fees quarterly based on lenders’ aggregate loan balances. The supporters of this approach argue that these updates support FHFA’s efforts to maintain rigorous loan quality while providing lenders with operational flexibility and financial predictability. That said, FHFA might be moving forward on this idea too quickly:

Pros and Cons of the Program

Cons

1. This policy could result in adverse selection. Freddie Mac could receive loans with a higher rate of defects as lenders with inferior quality control deliver increasingly to Freddie to avoid repurchases. (This could work the other way around depending on how aggressively Freddie enforces these fees). While this doesn’t sound like a big deal, as the program only covers minor defects, a lender with more minor defects might have other problems with loan quality that are going undetected. If the bad loans end up in one GSE, the chances that the taxpayer has to bail out that GSE goes up; one would prefer that both GSEs maintain a similar low-risk profile.

2. The program was tested in a low-volume lending environment. Loan volumes are down—especially refinance volumes. Because interest rates are so high now relative to the recent past, very few people are refinancing. Refinances are very different from sales. In a sale transaction, the home itself is less likely to have serious issues because the buyer does not want to be stuck “with a lemon.” In a refinance transaction, you don’t have this same level of transparency. Because interest rates are so high now relative to the recent past, very few people are refinancing.

This program should be tested in an environment where lenders are tempted to cut corners—where loan demand is high enough that loan officers can make serious cash by increasing their volume at the cost of quality. Minor defects that result from human error and those that result from consciously taking shortcuts might impact loan quality in fundamentally different ways. Freddie should see what happens to default rates when high loan volumes affect loan production.

3. The program creates a slippery slope: One has to wonder whether more and more defects will be included within the program’s scope over time. The program might eventually include defects that fundamentally affect the creditworthiness of the loans. We should remember the role that failing to properly document income played in the 2008 crisis. FHFA should be weary of embarking on any course that could open the economy to similar dangers in the future.

4. Small defects might indicate more significant problems that are harder to observe. We would never trust a scientific paper with significant grammatical errors even though we all acknowledge that grammar and science aren’t directly related. The quality of the writing gives the reader a sense of the care and attention paid to other aspects of the paper. Similarly, the minor details of a loan file indicate how much effort the loan officer and underwriter put into ensuring the quality of the loan. By allowing minor defects to skate by with a smaller penalty, Freddie might accept loans that are worse in more important respects.

Pros

1. It could create better incentives to note minor defects. Freddie’s internal reviewers may have been reluctant to note these defects because they feared the repurchase conversation. Now these reviewers might be more diligent in noting defects since it will bring in revenue rather than leading to a costly fight.

2. It might reduce transaction costs. Lenders fight repurchases tooth and nail. By moving away from repurchases, Freddie Mac will reduce the transaction costs associated with them.  Each repurchase demand involves extensive documentation review, negotiations, and appeals, all while managing operational costs. These contentious conversations, which in extreme cases may even result in legal action, can do major harm to the lender-GSE relationship. 

3. Reduced pressure on small lenders. The small lenders that Freddie Mac disproportionately works with might be unable to handle a slew of repurchase requests. This program will reduce the risk they face in this regard.

Nevertheless, Fannie Mae has not yet followed Freddie Mac regarding this fee-based approach. Given the pressure lenders put them under to reduce repurchases, Fannie likely has serious objections to the approach. It would be prudent to keep this program in pilot for longer—maybe even a few more years—so that Freddie can fully understand the costs and benefits. 

Franklin Carroll

Franklin Carroll is Kukun's VP of Modelling and Analytics; After finishing his studies at the University of Chicago, he worked at Fannie Mae where he helped build Collateral Underwriter, roll out the Value Verify initiative, and specialized in collateral related and credit related policy.

Published October 30, 2024