By recently releasing yet another revised representation and warranty framework, Fannie Mae and Freddie Mac continued their efforts to assuage the concerns of the lending industry that a default by a borrower poses an unfair risk of a loan repurchase demand. On October 7, 2015, Fannie Mae and Freddie Mac (the “GSEs”), at the direction of the Federal Housing Finance Agency (“FHFA”), announced a framework for  origination defects and remedies (the “Framework”) that expands on existing frameworks governing the rights and responsibilities of lenders that sell or securitize loans to or with the GSEs. For example, permitting repricing or cure in lieu of the remedy of repurchase represents a concession by the GSEs. Nevertheless, the language of the new Framework is ambiguous enough that one may have to rely on the GSEs’ apparent spirit of good intentions rather than the precision of their language to take total comfort in the changes.

Background
Contracts for the purchase and sale of performing residential mortgage loans generally involve detailed representations and warranties about the characteristics and features of the sold loans, such as their enforceability, compliance with law, and conformity with the eligibility criteria of the purchaser. Breaches of these representations and warranties generally result in two remedies — indemnification against losses resulting from the breach or, in some cases, repurchase of the loan. Questions of whether the remedy of repurchase is disproportionate to the amount of actual damages resulting from a breach long have been asked, particularly where the breach is technical or immaterial or did not cause the loss. Conventional loan purchase and sale agreements usually seek to address this concern by limiting the repurchase remedy to breaches that have a material adverse effect on the value of the loan or the interest of the purchaser; even this higher standard has led to substantial litigation over what constitutes a breach and whether a breach has had such an adverse effect. The GSEs’ selling guides, however, expressly reject the relevance of materiality on the availability of the repurchase remedy. The perception of many in the marketplace is that this express lack of a materiality filter has led to substantially more loan repurchase demands by the GSEs than would be available under a stricter standard, particularly since the appointment of FHFA as conservator for the GSEs. Some believe that this leads to credit overlays and more conservative lending than may be required in order to avoid the risk of a loan default and a resulting repurchase demand.

FHFA, Fannie Mae, and Freddie Mac listened to these industry concerns when they announced in 2012 a revised framework for selling representations and warranties pertaining to certain conventional loans sold on or after January 1, 2013. Rather than qualifying representations and warranties or available remedies with a materiality standard, the GSEs announced that they would forego exercising a repurchase demand for certain types of breaches of representations and warranties. Generally speaking, this new framework applied only to underwriting breaches, such as: (i) underwriting the borrower, which includes the lender’s assessment of the borrower’s loan terms, credit history, employment and income, assets, and other financial information used for qualifying the borrower for the loan; (ii) underwriting the subject property, which includes the lender’s analysis of the description and valuation of the property to determine its adequacy as collateral for the mortgage transaction; and (iii) underwriting the project in which the property is located, which includes the analysis of the planned unit development, condo, or co-op project in accordance with the GSEs’ eligibility requirements. The GSEs, however, restricted the availability of this new paradigm to borrowers who met one of two payment history requirements within the first 36 months after loan sale. Moreover, the GSEs limited these new requirements to underwriting breaches, expressly excluding certain other types of breaches of the loan-level representations and warranties, such as loans that violated the GSEs’ respective statutory charters or anti-predatory lending policies, violations of law, ineligible product types, title defects, data inaccuracies, and certain types of pattern and practice misrepresentations or fraud by borrowers and others involved in the making of the loan. Fannie Mae and Freddie Mac refined these standards in 2014, including broadening the payment history requirements to give lenders a little more leeway for limited delinquencies by borrowers. [1]

Despite a positive industry reaction to these developments, some major concerns remained unaddressed. First, the framework did not apply to loans sold prior to 2013. Second, concessions on underwriting required a 36-month seasoning regardless of the materiality of the breach. Third, the framework only applied to underwriting breaches. The new Framework responds to some of these concerns.

The New Framework
The Framework describes the GSEs’ processes for (i) categorizing origination defects during full-file quality control reviews, (ii) permitting a lender the right to correct the defects prior to enforcement, and (iii) assessing whether to offer a repurchase alternative for significant defects. In addition, key terms are defined, some in significant detail, and the scope of the GSEs’ discretion in categorizing defects and assigning remedies is described. The Framework is effective for loans sold to or securitized with the GSEs on and after January 1, 2016.  It supplements but does not replace the GSEs’ earlier initiatives.

Categorizing Defects
The Framework describes three categories of loan-level origination defects that may be assigned during any full-file quality control review.

To assign a Significant Defect, the GSE must give due consideration to the severity of the defect, with only certain types of breaches qualifying for the classification. Eight types of breaches are listed, including breaches relating to underwriting (of the borrower’s creditworthiness or the property and/or project eligibility); mortgage loan or product terms and criteria; life-of-loan representations and warranties (as described, for example, in Section A2-2.1-06 of the Fannie Mae Selling Guide); requirements applicable at the time of loan purchase; the existence, sufficiency, or enforceability of insurance; and the form and/or execution of certain GSE-required documents. Significant Defects will be detailed in repurchase letters, consistent with prior practice.

The Framework also notes that following a review, the GSE may request data updates for loans with Findings and may also check for data discrepancies in other loans, which could result in the further assessment of LLPAs or Delivery Fees.

Lender Corrections
While previous GSE frameworks detailed the appeal process for contesting GSE findings, the Framework expands on the application of this process to the resolution of origination defects. Importantly, the Framework provides guidelines for corrections, including “de minimis corrections” of defects. A lender has the right to provide a correction for any Significant Defect in the time frame and manner specified in the applicable Selling Guide.

The Framework defines a correction as action by a lender (typically through submission of documentation) that demonstrates (i) the defect did not exist at the time the loan was purchased or securitized, or (ii) that, since the sale or securitization of the loan, the defect was corrected during the time frame and in the manner required in the GSE’s Selling Guide. Further, correction documentation must be based on information that was available at the time of underwriting (and no later than the note date) or information that covers the time of underwriting if it meets the applicable requirements under the lender’s GSE agreement.

A de minimis correction is defined as the payment of a minor amount, not more than $500 (or such higher amount as the lender and the GSE agree), that, when remitted, refunded, or otherwise provided, corrects or otherwise resolves a Significant Defect. The definition prohibits use of a de minimis correction in instances where the defect constitutes a violation of GSE charter requirements or where payment of the amount prescribed would cause a failure of a specific required minimum borrower contribution.

If a lender submits corrections for all Significant Defects for a loan, the GSE will rescind or close out the remedy request related to such loan.

Available Remedies
Each GSE may offer a Repurchase Alternative for a loan with one or more Significant Defects based on its commercially reasonable determination that the loan is retainable. In making this determination, the Framework describes several other factors that the GSEs may consider, such as the lender’s counterparty status (to the extent there are future obligations required under the prescribed Repurchase Alterative), the lender’s failure to maintain a “quality loan origination process,” and the lender’s “ability and willingness to comply” with other provisions of the GSE’s Selling Guide. A lender may also request a Repurchase Alternative if one is not offered by the GSE during the appeals process. If a Repurchase Alternative is offered, the lender retains the option to repurchase a loan. The specific Repurchase Alternatives described in the Framework are as follows:

No remedy is required for a loan with a Finding. The lender must pay an LLPA or a Delivery Fee, as applicable, for each loan with a PAL.

Sunset
The Framework describes two instances in which a loan will be afforded origination representations and warranty relief after a full-file quality control review:

1. If a loan has only Findings after the review; and
2. If a loan has a PAL and the lender pays the required LLPA/Delivery Fee.

It is clear from the Framework that such relief is subject to any life-of-loan representations for loans with Findings, but the Framework fails to specify whether this is the case for loans with resolved PALs. It seems safe to conclude that this was an oversight by the GSEs and that relief for loans with resolved PALs is also subject to any life-of-loan representations applicable to such loan.

Reaction
There is no doubt that the new Framework is an improvement over the existing approach. At some level, the Framework parallels the Federal Housing Administration’s (“FHA”) currently stalled efforts to develop a “taxonomy” for classifying the severity of origination defects and varying the remedies available to FHA based on such severity. Unlike the prior two initiatives by the GSEs, the new Framework extends its applicability beyond underwriting errors. By its terms and like the two prior initiatives, the Framework will not apply retroactively although the GSEs always have the discretion to elect to apply similar concepts to legacy sales. The most difficult aspect of the new Framework for lenders is ambiguity over what constitutes a “significant defect.” Because the standard provided is whether the defect would have rendered the loan ineligible for sale, and the respective Selling Guides do not qualify eligibility criteria by materiality, in theory virtually anything could be a “significant defect.” At the same time, the GSEs have bound themselves to consider the severity of the defect in determining its significance. All in all, this is a highly positive step for the GSEs. They have made it harder to rely on a seemingly innocuous breach of a loan-level representation and warranty to reallocate the risk of loss on a defaulted loan back to the seller or servicer.

Notes:
[1] Both Fannie Mae and Freddie Mac announced further changes to the revised framework after their respective 2014 announcements.

[2] The Framework notes that the GSEs may not demand repurchase of a loan categorized as a PAL, nor may the lender voluntarily repurchase it.