Mortgage lenders commonly sell their loans -- meaning, they sell the right to collect the payments borrowers make on their mortgages. Investors who buy those mortgages expect that the lender took the necessary steps to ensure that the borrower could afford the loan and would be likely to pay it back. If it turns out such steps weren't taken, the investor can ask that the lender buy back the mortgage.
In most cases, when you take out a mortgage to buy a home, the lender doesn't actually hold onto your mortgage for the full term of the loan. In other words, even though you borrowed money from ABC Bank, you probably won't be repaying that money to ABC Bank. Lenders usually sell their mortgages on the "secondary market," where they're bought by investors or by repurchasers who essentially turn those mortgages into securities to sell to investors. Lenders get their money back without having to wait for years' or decades' worth of payments, and they can then lend that money to other borrowers immediately. The investors, meanwhile, get a source of income: the borrowers' mortgage payments.
Warranties and Representations
Lenders looking to resell their mortgages on the secondary market typically have to provide potential investors some assurance that the loans won't go into default -- that the borrowers actually have the ability to make the payments that the investors will be counting on for income. Resale agreements typically include language in which the lender promises that it performed due diligence before extending the loan, by examining the borrowers' finances and verifying that the homes bought with the mortgages were worth the money. If these promises, called "warranties and representations" turn out to be false, the investors can call upon lenders buy back their mortgages.
Though they're known in the mortgage industry as buyback requests -- or, sometimes, putback requests -- such "requests" are actually demands. Mortgage repurchasers have tremendous leverage over lenders, because lenders need the liquidity they provide. Without the ability to sell their mortgages, lenders would end up with all their available capital tied up in borrowers' houses, and that capital would only come trickling back over the course of 30 years. Denying buyback "requests," then, isn't a practical option, even though fulfilling them can be extremely costly. However, resale agreements often provide some mechanism for lenders to at least appeal the request.
Fannie and Freddie
By far, the largest mortgage repurchasers -- and the largest issuers of buyback requests -- are Fannie Mae and Freddie Mac, two corporations chartered by the federal government to provide liquidity to the mortgage market. In the housing price collapse of the mid- to late 2000s, the two corporations suffered such enormous losses from failed loans that the government had to step in to keep them from failing. Under new rules that took effect in 2013, Fannie and Freddie changed their process for buyback requests. Previously, they didn't examine mortgages until those loans went into default -- essentially taking lenders' word for it that the loans were good. Starting in 2013, three months after it buys a batch of loans from a lender, Fannie or Freddie examines a representative sample of those loans. If the warranties and representations are sound, the lender is released from its buyback obligation for that batch. The point of the change is to catch bad loans earlier while giving lenders more certainty about their buyback exposure.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.