The Federal Housing Finance Agency's Office of Inspector General (FHFA OIG) has released an evaluation of Fannie Mae's and Freddie Mac's (the GSEs) increased recent level of purchases of loans from small banks, credit unions, and non-bank mortgage companies.  Such purchases, OIG said, presents both potential benefits and certain risks.  

Historically the GSEs have purchased loans from large commercial banks and other financial companies that acted as loan aggregators by purchasing mortgages originated by smaller lenders and bundling them with their own loans for sale.  The aggregation system offered several benefits to participants:

• Aggregators received volume discounts on guarantee fees and passed a portion on to smaller lenders.
• Aggregators usually acquired associated servicing rights for the loans they purchased, gaining ongoing fee income and cross selling opportunities to the borrowers they serviced.
• The aggregators provided an additional layer of review to ensure loans met GSE underwriting standards.
• The GSEs did not have to track the financial condition and loan compliance of hundreds of small lenders.
• Aggregators may have had more financial capacity to honor GSE repurchase demands.

This system changed radically after the housing crisis.  Fannie Mae recently reported that only 5 of the top 20 mortgage originators in 2006 are currently active in the mortgage market, having failed or been absorbed by other lenders.  Moreover several large aggregators have stopped purchasing mortgages originated by other lenders while others have reduced their aggregation activities.  In early 2011, the GSEs' top five sellers delivered between 65% and 70% of the mortgages purchased by each GSE.  By the third quarter of 2013 these purchase had dropped to less than half.

In response many credit unions, thrifts, smaller banks, and nonbank mortgage companies have stepped up their direct sales to the GSEs which have seen a steady increase in their number of their active mortgage seller counterparties.  Between late 2007 and late 2013 this number grew by an average of about 30% for the two GSEs.  At Fannie Mae, the smallest sellers-those outside the top 50-gained the most market share, increasing from 8% to 22%, while it was mid-tier sellers at Freddie Mac which expanded market share from 24% to 43%.

Lenders can sell loans to the GSEs in one of two ways.   They can swap the loans for GSE mortgage backed securities backed by the same loans then sell them to investors or they can sell the mortgages to the GSEs for cash after which the GSEs securitizes the mortgages and sell them to investors themselves.  Either way the mortgages end-up as part of a GSE mortgage-backed security (MBS) and lenders obtain cash they can use to make additional loans, creating liquidity for the housing finance market.

In exchange for a "the guarantee fee," the GSEs guarantee that investors will continue to receive the timely payment of principal and interest on their MBS regardless of the credit performance of the underlying mortgages. The GSEs have established ongoing post-purchase quality reviews to determine conformance with their underwriting standards and may require lenders to repurchase mortgages that do not comply.  Since the financial crisis the GSEs have recovered nearly $100 billion through assertion of repurchase claims.

Traditionally, smaller lenders have sold their mortgages to the GSEs for cash because such sales are less operationally challenging than MBS swaps so it is not surprising that the market share of cash-window sales has increased significantly over the past few years.  Those sales grew to between 20% and 25% of each GSEs' total mortgage purchase volume by late 2013 with Fannie Mae's cash window sales increasing at a faster rate than Freddie Mac's.

In conducting its evaluation, OIG identified several reasons why the surviving aggregators may no longer serve as conduits for small lender loans.

• A high volume of repurchase requests from GSEs for legacy mortgages they purchased between 2005 and 2008 has led large banks to reduce future exposure to loans originated by other lenders and increase their scrutiny of mortgages they do acquire.
• Increased GSE guarantee fees have caused large banks to realize less compensation for assuming the risks of representation and warranty liability from small lenders.
• Because of new banking financial regulations that require higher levels of capitalization large banks have prioritized their own lending over purchasing from third parties.

Enterprise data also indicate that sales from nonbank mortgage companies, i.e., those unaffiliated with commercial banks, represent a growing percentage of their mortgage purchases. According to Fannie Mae documents, 46.6% of its mortgages were purchased from nonbank mortgage companies in the first three quarters of 2013, which was up from 33.2% in 2011. Freddie Mac data shows that its share of mortgage purchases from nonbank mortgage companies more than doubled from 8.4% to 20.5% over that same period, but its share remains significantly lower than Fannie Mae's share.

OIG concluded that the recent shift in sales to smaller and nonbank lenders while reducing the GSEs' concentration risks, a product of their financial exposure to a few large commercial banks, may have led to new risks and challenges.  

• Elevated Counterparty Credit Risks. This is a risk that a counterparty will default on representation and warranty obligations. The GSEs' traditional top sellers, large commercial banks, are generally well capitalized and are regulated by federal agencies to enforce these capital standards, and have financial strength that allows them to fill their responsibilities. In contrast some smaller and nonbank lenders have relatively limited financial capacity and the latter are not subject to federal safety and soundness oversight. Consequently, the GSEs could incur financial losses on mortgages purchased from such lenders if they do not comply with established underwriting guidelines. There are already questions about the long-term viability of some of these counterparties as the refinance boom winds down.

• Operational Risks. Some smaller lenders may lack the sophisticated systems and expertise necessary to manage high volumes of mortgage sales to the GSEs. This could result in potential quality control and fraud management and regulatory compliance problems.

The change in the composition of sellers may also increase the GSEs operational and costs.  The increasing number of lenders will require more resources to monitor financial strength and compliance and the informal regulatory role formerly played by the aggregators has also disappeared from the sales equation.

• Elevated Reputational Risk. Buying loans from some nonbanks could damage GSE reputations if, for example, they bought loans from a lender later revealed to have harmed consumers through fraud or other misconduct or if several of the entities failed as could occur under adverse market conditions.

OIG confirmed that since at least 2012 FHFA has been aware of the risks associated with the increased sales to the GSEs by these smaller entities.  The GSEs have reportedly taken steps to mitigate these risks but due to other examination priorities, FHFA has not specifically tested and validated them.  FHFA indicates it plans to conduct several examinations of GSE management of these counterparties in 2014 and is developing guidance intended to strengthen the GSEs' management of risks associated with them. OIG said it will continue to monitor FHFA's efforts to oversee this critical issue.