A brief primer on how a Fannie Mae Repurchase request works.

Banks underwrite loans to Fannie Mae or Freddie Mac guidelines (and in the good old days, the guidelines issued by Wall Street). For ease of writing, I will refer just to Fannie. Loans underwritten to Fannie’s guidelines can be sold, in bulk, to Fannie. Banks get paid a premium for delivering these loans — the premium is a complex calculation of what Fannie expects to realize from the loan over the course of the loan (used to be 5 to 7 years, but it went down to less than 5 years during the boom because borrowers would refinance every year or two), and what the bank is giving up by not keeping the loan and realizing it themselves versus having cash on hand now (and not tied up in the loan).

When a bank first starts selling directly to Fannie, the initial set of loans are subject to an audit before they are purchased. After a certain pre-purchase audit period, Fannie will just accept all loans as long as certain data fields and important documents (loan app, note, deed of trust/mortgage, etc.) are included. Fannie will then perform a random QC post-purchase audit, or audit a delinquent loan to check for deficiencies. If deficiencies are found during these audits, the banks are asked to respond to the deficiencies or repurchase the loan.

Repurchases used to have a time limit on them, unless it involved fraud. For example, in some instances repurchases for mere default of a loan after 3 years, say because the borrower lost her job, without any other deficiencies, would not be subject to a repurchase, but if there were underwriting deficiencies, then it would be subject to a repurchase. Generally, these limitations are governed by the master purchase agreement between Fannie and the bank.

When a bank repurchases a loan, it needs to pay back the premium it received at sale, increase its loss reserves, and deal with the “bad" loan. If the loan is in default, then the bank will most likely initiate foreclosure proceedings, and should be doing it in parallel to exploring a scratch-and-dent sale (see below). If the loan has underwriting deficiencies, then the bank will try to pursue recourse against third-parties…brokers (good luck), mortgage insurance companies who may have underwritten the loan, etc. For all of this, the bank needs to have robust procedures in place.

Typically, a bank would want to start its recourse process as soon as it receives a request from Fannie (regardless of whether it can be overturned or not) because time is of essence. An alternate to foreclosing for a bank is to create a pool of similar “bad" loans and send it out for a scratch-and-dent bid. Such bids come back at pennies on the dollar depending on the characteristics of the pool (performance, LTV, interest rate, loan amount, etc.). Many banks prefer this because they can quickly realize their losses, take the hit, and move on as opposed to having capital tied up in real estate until foreclosure is completed. “Quickly" is a relative term. Nothing moves quickly in banking and real estate, but it is quicker than foreclosure, which the ultimate buyer of the pool of loans may pursue. Contrary to popular public perception, banks typically do not want a borrower’s real estate. They are in the business of loaning money, and having money tied up in a depreciating asset is no way to make money.

By the way, banks don’t just roll over and buy loans because Fannie says so. If they have the right procedures in place for risk management, they will fight the underwriting deficiency allegations tooth-and-nail. It’s a fine line…a bank doesn’t want to tick off Fannie because too many outstanding requests without a legitimate reason will result in increased audits and/or suspension from selling any more loans, and if a bank buys back without sufficient due diligence, it will tie up its funds and not be able to make more loans (read bankruptcy).