Fannie Mae and Freddie Mac are about to get tougher on banks and other lenders that cut corners when originating mortgages and try to sell them to the government-sponsored enterprises.

For the first time ever, the GSEs are creating formal programs to flag defective loans and assess risks in lenders' mortgage processes. Lenders will be graded and receive feedback on areas such as underwriting, quality control and governance and, if loans are defective, the GSEs will require lenders to immediately repurchase them. In the past, it might have taken years for the GSEs to spot defects and force a lender to repurchase a loan.

"Our expectation is zero defects," Steve Spies, a vice president of loan quality and lender assessment at Fannie Mae, told a group of risk managers at an industry conference last week.

Theoretically lenders have always been required to sell only quality loans to Fannie and Freddie, but GSE officials admit that their review processes were not always able to flag problem loans before they soured. Specifically, the GSEs have started electronically validating 100% of the loans they purchase, a significant change from the past when they only reviewed a sampling of loans they acquired or examined loans after they defaulted.

All reviews will be conducted within 120 days after Fannie and Freddie buy a loan.

"It's a whole new world from a loan quality perspective," Spies said. "We want to focus on quality individual file data, which is something we haven't done in the past."

GSE officials say that lenders are equally responsible for reducing losses on mortgage loans and are urging them to improve their oversight.

The GSEs have found that a majority of underwriting defects are due to "a widespread lack of control in the management of file documents," where the lender failed to obtain or provide copies of all required paperwork to support a loan decision.

"Quality is an equal partner to production," Spies said. "Building a culture of quality is really what we're looking for. If your senior manager can't talk to us about loan quality then your governance evaluation is going to be weak."

The GSEs' initiative has taken on added urgency as interest rates have risen in recent months. Already banks have started to relax lending standards and the GSEs are counting on its new processes to catch problem loans before they buy them.

"As rates go up, the credit box will try to be expanded, corners will be cut and that's when we will be on the front lines," Chris Mock, Freddie's vice president of quality control, said at the conference.

Defects range from a missing credit report to incorrectly calculating a borrower's income, and many can ultimately be fixed by the lender.

Fannie and Freddie already are giving large lenders feedback on loan reviews. In addition to random samplings, Fannie will target an additional 10,000 to 12,000 loans per month that its internal models indicate may have problems, Spies said. The GSEs want lenders to review 10% of the loans in which the quality control process has been outsourced, part of an effort to monitor counterparty compliance.

Fannie now has 500 employees working on various initiatives to ensure that lenders originate quality loans with no defects that follow its guidelines. Freddie has 250 employees working on its quality control processes.

The push to improve loan quality began last year, when the Federal Housing Finance Agency, which oversees Fannie and Freddie, created a new "representation and warranty" framework to help reduce the risk to lenders of mortgage buybacks.

The framework has been praised by banks and mortgage lenders for a key component: lenders get relief from some repurchases as long as a loan performs for three years. Loans refinanced through the government's Home Affordable Refinance Program are eligible for relief after just a year of consecutive on-time payments. Lenders still have to comply with federal, state and local consumer protection laws for the life of the loan.

Still, Becky Walzak, president of Walzak Consulting in Deerfield Beach, Fla., says the push for quality control will be expensive.

Many banks and lenders will need to increase staff and oversight of their mortgage origination process to comply with new requirements that go into effect in January. The GSEs' lending guidelines are already 1,000 pages, and keeping tabs on the constant revisions and updates will be difficult, Walzak says.

"They want lenders inspecting every single loan and sending it back if it's not right, and that is so extremely expensive, lenders cannot afford to do that," she says. "They want more people looking at compliance and loan quality, so now we have this subpopulation of people at these lenders checking the checkers and paying for it. That's why the cost of a loan will go up."

The GSEs have argued, though, that changes need to be made to avoid a repeat of the housing bust.

Over the last five years, banks and lenders have had to repurchase scores of defaulted and performing loans that did not meet GSE standards. The FHFA has sued 18 banks for misrepresenting the quality of mortgages packaged into bonds during the peak of the housing bubble. It has settled with three lenders so far: UBS AG, Citigroup (NYSE:C) and General Electric (GE).

Since last year, Fannie and Freddie have been reviewing all legacy loans and expect to issue repurchases on loans acquired between 2005 and 2008 by the end of the year. As of June, Fannie had completed reviews on 89% of legacy loans. Freddie's buyback requests may roll over into 2014, said Mock.

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