Freddie Mac is picking its battles with mortgage servicers carefully.

It appears unlikely that the government-sponsored enterprise will take a hard line on enforcing contracts with servicers that have identified foreclosure documentation defects in recent weeks — though it believes some of those contracts may have been violated.

"While we believe that our seller/servicers would be in violation of their servicing contracts with us [if] they improperly executed documents in foreclosure or bankruptcy proceedings, … it may be difficult, expensive and time-consuming for us to enforce our contractual rights," Freddie said in its third-quarter report filed with the Securities and Exchange Commission Wednesday.

What's more, Freddie said, trying to enforce those rights could hurt its relationships with the big lenders, "some of which are among our largest sources of mortgage loans." More than half of Freddie's purchase volume comes from just three lenders: Bank of America Corp., JPMorgan Chase & Co. and Wells Fargo & Co. — all of which have admitted to finding flaws in the execution of foreclosure documents, namely, that affidavits were not processed in the presence of a notary or signed by a person with first-hand knowledge of the information in them, as required by law.

Freddie warned that any delays in foreclosures related to the document deficiencies could significantly raise its costs and lead to bigger losses. For the time being, Freddie seems to be giving servicers a chance to work through the problems.

"Because of the relationship, I think the GSEs want to give the servicers a chance to identify where the issues are and rectify them," said Susan E. Reid, general counsel at McCalla Raymer LLC and a former in-house lawyer at Fannie Mae.

"It's not that dissimilar to repurchase requests, in the sense that they have a business relationship with large institutions and the servicing industry is very concentrated," said Brian Harris, a senior vice president at Moody's Investors Service.

However, Freddie seems less willing to budge on repurchases.

The GSE disclosed in August, and reiterated in Wednesday's filing, that it was beginning to include requirements in its annual contract renewals with certain of its large seller/servicers to complete repurchases or else risk "financial consequences."

Reid said Freddie may seem more hesitant to enforce servicer contracts over potential violations related to foreclosure documentation defects because these are not as clear-cut as some of the errors that occurred in the underwriting of loans that are being put back to servicers.

"In some situations it could very well be that … it was improper for the person to execute the affidavit because they did not have personal knowledge but nevertheless the facts are correct," she said. "From the GSEs' standpoint, it would seem to me they really wouldn't want to go back to the servicer and say, 'You've got to repurchase thousands of loans,' when there are varying degrees of what the issue was.

"As this plays out, it could very well be that the GSEs take a harder look at the servicers and say, 'We think there was something systemically wrong with the process, and we may need to kick back some loans to you,' " she said. "It will also depend on how the courts are going to view it."

Meanwhile, Freddie has its hands tied in dealing with outstanding repurchase requests.

At Sept. 30, the unpaid principal balance of loans on which repurchase requests had been made stood at $5.6 billion, up from $4.2 billion at the end of last year. As of the end of the third quarter, about 32% of the buyback requests had been outstanding more than four months after issuance of a repurchase demand, Freddie said. And four of the larger servicers Freddie works with collectively had 34% of their repurchase obligations outstanding for more than four months as of Sept. 30.

During the third quarter, Freddie recovered $1.7 billion through repurchase requests.

Still, Michael Youngblood, a principal at Five Bridges Advisors LLC, said Freddie and Fannie must walk a fine line with servicers when it comes to repurchases.

"Both of the GSEs face a dilemma in handling any deficiencies with respect to the underwriting or documentation of mortgage loans that they've either guaranteed or acquired, and the dilemma is straightforward," Youngblood said. "On the one hand they have an interest in minimizing losses by requiring repurchase of these loans where any deviations from underwriting criteria or any deviations in documentation are material. On the other hand they also have an interest in acquiring or guaranteeing new mortgage loans from the same servicers who are under pressure to repurchase."

In reporting its third-quarter results Wednesday, Freddie said it lost $4.07 billion in the period, after a $1.6 billion dividend payment to the government.

The net loss was smaller than in recent quarters; the GSE reported a net second-quarter loss of $6.01 billion after preferred stock dividends and a $6.70 billion loss a year earlier.

Freddie said it set aside $3.73 billion during the period to cover future loan losses, down from $5.03 billion in the second quarter and $7.97 billion in the third quarter of 2009.

Loan performance also improved. The serious delinquency rate on single-family residential loans in Freddie's portfolio stood at 3.8%, down 16 basis points from the second quarter, but 37 basis points higher than the year earlier.

As a result of the dividend payment, Freddie had a net worth deficit of $58 million at the end of the quarter. It said it would seek an additional $100 million in funds from the Treasury to plug the deficit.

To date, the government has pumped $148 billion into Freddie and Fannie.

Fannie Mae is expected also to report its third-quarter results this week.

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