Lawsuits concerning Fannie Mae and Freddie Mac's underwriting systems could foretell liability risks for banks or at the very least undercut the speed and efficiency the systems have brought to the mortgage process.
A pair of consumers in separate suits against the government-sponsored enterprises - which do not name any lenders as defendants - charge that because they were not told why several conforming lenders rejected their loan applications, the underwriting systems violate the Fair Credit Reporting Act.
But when applications are "referred" by Fannie's Desktop Underwriter or Freddie's Loan Prospector, the systems do tell the lenders why. Furthermore, the GSEs argue that the decision to make a loan rests not with them but with lenders, and that the systems are meant to guide those decisions, not dictate them.
Experts say that by that logic, the widespread industry practice of application "tweaking" - when a loan officer adjusts loan terms in order to get a yes from one of the secondary-market giants' underwriting systems - could become a legal minefield.
And observers note that the speed and efficiency the systems have afforded would be weakened if banks were forced to explain to consumers the rationale of every answer the systems spat out.
Automated underwriting technology has been championed by the GSEs for more than five years, and the systems have become the main gateway to the secondary-market giants. They analyze a borrower's credit risk and tell a lender whether Fannie or Freddie would be inclined to buy the loan.
The suit against Fannie was filed in September in U.S. District Court in Washington and the one against Freddie was filed in October in U.S District Court in Philadelphia. Both say the influence of the underwriting systems led to violations of the plaintiffs' rights under the Fair Credit Reporting Act.
Both consumers charge that they shopped around for loans that would fit the GSEs' guidelines, were rejected by several lenders, and were never told why. The applicant suing Fannie eventually got an offer for a loan that would cost 10.5%, 375 basis points more than the loan she had sought, the complaint says.
Freddie Mac spokeswoman Sharon McHale said Thursday: "The decision that lenders get when they run an application through Loan Prospector is simply whether we will purchase a loan outright or, if they get a refer or caution, that the lender needs to take a look at it. Ultimately, it is the lender's decision whether they want to approve or deny the loan. This tool just helps you determine whether Freddie will purchase it."
Fannie Mae makes the same case in a motion filed in November to dismiss the suit against it. It noted that the borrower did not choose to sue the lenders that turned her down and that "by law, Fannie Mae cannot originate mortgage loans; it can only purchase them."
Mortgage experts said this argument could hold water because both GSEs' automated underwriting systems give lenders fairly comprehensive explanations why a borrower was considered too risky for a conforming loan.
"Automated underwriting is a very important tool and very pervasive throughout the industry, but it is not the final answer on whether a borrower will be able to get a loan or not," said Allan Redstone, the chief executive of GHR Systems Inc., a mortgage software provider in Wayne, Pa.
Sandra Traicoff, who heads the financial regulatory practice of Howard & Howard Attorneys PC in Bloomfield Hills, Mich., said mortgage lenders in general are doing a good job of relaying explanations from Fannie and Freddie to consumers when the systems reject applications outright. Consequently, most lenders have little to worry about in those situations.
The risk lies in middle-of-the-road situations. Often, if Desktop Underwriter or Loan Prospector rejects an application on the first try, the loan officer will resubmit several more times, adjusting various terms such as rate, maturity, or down payment in order to negotiate an acceptance. Usually the borrower is not told of all these adjustments until after the application has been accepted.
Banks that use this common practice could face lawsuits similar to those Fannie and Freddie are now fighting, Ms. Traicoff said. Under the Fair Credit Reporting Act, a consumer must be alerted to every credit-related decision that could be perceived as hurting their chances of getting a loan or getting one on good terms. Raising a mortgage rate 5 basis points to gain acceptance could be an example of such a decision, Ms. Traicoff suggested.
If this practice gets more legal scrutiny, Ms. Traicoff said, lenders would hesitate to casually tweak loan applications. To avoid the risk of being sued, they would explain and get the applicant's approval for every change, no matter how minor, she said. That would obviously be time-consuming.
"If the courts decide that every time a loan officer tweaks an application, they have to tell the borrower - if you stop and think about that, it would be a virtual impossibility," Ms. Traicoff said.
Jess Lederman, a senior vice president at Ohio Savings Bank in Cleveland, had a similar view. "The whole point of relying heavily on automated underwriting is to make the process efficient," and having to check so many things would be counterefficient, he said.
But Mr. Lederman said that though lenders, in the end, have the say-so on a loan, it is not easy to ignore the automated underwriter's guidance. "The ultimate decision is with the bank, but as a practical matter it is really the automated underwriting system that is driving the decision," he said.
Scott Cooley, an independent technology consultant, agreed that it has become hard for lenders to aggressively question each and every decision made by the systems.
"In all practicality, in more than 99% of that cases that Desktop Underwriter or Loan Prospector will approve a loan, the lender will do the same," Mr. Cooley said. "For all intents and purposes, automated underwriting practically makes the decision."
Mr. Lederman, however, said that reliance on automated underwriting for streamlining operations is not an excuse for a lender to avoid responsibility for its loan decision, and he considers the suits against Fannie and Freddie to be without merit.
"AU systems take the potential for human prejudice out of the equation," Mr. Lederman said. "It is the solution, not the problem."
