When I first read the Federal Housing Finance Agency Inspector General’s report criticizing Freddie Mac’s $1.35 billion MBS put-back settlement with Bank of America, I wondered if the FHFA IG had just exposed billions of dollars in untapped bank liability. The IG report notes, after all, that Freddie’s deal with BofA (unlike Fannie Mae’s simultaneous $1.52 billion BofA settlement) resolves not only pending breach of contract claims, but also any future claims that Countrywide breached representations and warranties on the mortgages it sold Freddie. Those are exactly the kinds of global settlements banks are going to have to reach if they have any hope of resolving their MBS put-back liability.
So if the FHFA Inspector General is castigating Freddie for overlooking BofA’s liability for mortgages that defaulted four or five years after they were issued — and FHFA is generally reckoned to be the most experienced evaluator of reps and warranties claims there is — have other put-back claimants underestimated potential bank liability? Are bond insurers and MBS investors making the same supposed mistake as Freddie Mac?
The short answer is no.
The IG report faults Freddie for failing to account for the exotic mortgage loans that proliferated in the housing bubble. Homeowners with interest-only or adjustable-rate mortgages often made it through the early teaser-rate years, only to default when they had to begin making higher payments. The FHFA IG report indicates that Freddie Mac has seen tens of thousands of these mortgages go into default three to five years after they were issued.
That changed the traditional default bell curve, in which deficient mortgages went sour within a year or two and default rates slowed thereafter. But according to the FHFA IG, Freddie never adjusted its process of reviewing defaulted loan files to reflect the changed default model. The government agency continued looking for breaches of reps and warranties in loans that went bad within the first two years after they were issued, even though the exotic mortgages of the housing boom frequently took longer to sour. As a result, the report said, Freddie may have severely underestimated its put-back claims against Countrywide.
“By choosing to review intensively only those loans that defaulted within two years of origination,” the IG report asserts, “Freddie Mac did not examine close to 100,000 2006 vintage loans.Those loans that were not reviewed have a combined unpaid principal balance exceeding $50 billion.” The report cited a senior FHFA examiner who estimated that BofA’s liability for those unreviewed loans could run to billions of dollars, although in a footnote deep in the report the IG quoted a more moderate estimate of $500 million to $1 billion in total additional revenue (not just from BofA) for Freddie if it changed its loan review process to account for later-defaulting mortgages.