Within the last few weeks, a sustained buzz surrounding new changes at the Federal Housing Finance Agency, Fannie Mae (NASDAQOTCBB: FNMA ) and Freddie Mac's (NASDAQOTCBB: FMCC ) conservator, have investors optimistic about the future of the two government sponsored entities (GSEs).
But a positive attitude about those changes may be better suited for the businesses directly effected -- the nation's mortgage originators.
Big story, fast-fading response
Back in May, within the hours following an eye-opening speech from FHFA head-honcho Mel Watt, both Fannie and Freddie were up nearly 10% as investors took Watt's words to mean that the future of the GSEs was solidifying -- though my fellow Fool Patrick Morris demystified that notion thoroughly.
Since mid-May investors have cooled a bit on the news, though both GSEs still sit nearly 4% higher than pre-speech share price levels. But with the legislative future still very fuzzy for Fannie and Freddie, another group of stocks may experience a longer lasting boost from the news, though few have examined what Watt's announcements mean for them -- the nation's biggest mortgage originators.
Battle over buybacks
One of the big revelations of Mel Watt's speech was the adjustment of guidelines for when either Fannie or Freddie would require a bank to buyback a failing loan.
Acting under a statutory mandate from its conservatorship to attempt to reclaim losses, both GSEs have sued the nation's biggest mortgage lenders over delinquent and non-performing loans. A total of 18 law suits were filed in relation to $200 billion in mortgage-backed securities. Between 2011 and 2013 alone, lenders had to absorb the costs of $81.2 billion in buybacks.
From 10 settlements, Fannie Mae and Freddie Mac have recorded $19 billion this year alone. Most recently, Bank of America (NYSE: BAC ) settled with Fannie Mae and Freddie Mac to the tune of $9.3 billion ($6.3 billion in cash and $3 billion in securities), the second such settlement for the bank with the GSEs. In total, Bank of America has paid out nearly $20 billion to the GSEs, split between cash settlements and securities or loan repurchases.
It's no surprise then, as Watt noted in his speech, that the banks are still concerned with the amount of uncertainty surrounding repurchasing risks, resulting in continued use of strict qualification standards.
Since the financial crisis, most banks have enacted standards that include "overlays," which are requirements above and beyond those required by the GSEs for conforming loans. Overlays may be higher credit score requirements or higher down payments, among other hurdles designed to weed out riskier borrowers. Those overlays are considered a big hindrance to the recovering housing market, dissuading mortgage newcomers from coming into the market or disqualifying borrowers that would historically be creditworthy.
Banking on change
The announced changes for the GSEs' buyback requirements came in a three-pronged approach to assuage some of the banks' biggest concerns about loosening credit qualification standards:
- Eliminating repurchase liability for banks when loans have successfully passed the 36-month mark, even if there were two late payments during that time period
- Enacting spot-checks for mortgages sold to the GSEs, with repurchase liabilities wiped out if the loan passes that inspection
- Reducing the frequency of required repurchases by banks to cover losses for bad loans, if mortgage insurers refuse to pay a claim
The new approach will go into effect as of July 1, giving the banks a bit of time to evaluate their position on loosening credit standards for the crucial summer sales season. Nevertheless, though the FHFA and Watt may have given the nation's banks a good starting point for softening their credit standards, there's currently nothing that the agency can do to force the issue.
In response to a question about Watt's comments, Bank of America (NYSE: BAC ) CFO Bruce Thompson stated that the changes are positive from a policy perspective, but as a lender, the bank is interested in generating loans that will provide revenue and avoid the costs of delinquency. Thompson went on further, "[a]s we move forward, we're just not interested in putting on loans that are going to have heavier-than-average delinquent content."
Though the banks may continue to be leery of forced loan buybacks and cash settlements, despite the proposed changes outlined by Watt, it may be in the best interest of all parties to loosen some credit standards. It's not a secret that investors have been disappointed by the declining origination figures posted by the nation's top banks, so expanding the availability of credit to traditionally creditworthy borrowers may help boost the banks back to record profits.
For now, we'll have to wait until the changes noted by the FHFA's Watt are finalized and officially enacted to see how the banks move forward.
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