Big Lenders Fear
Two Mortgage Giants

COLUMBIA, Md. -- For organizations created to advance the wholesome-sounding cause of home ownership, Fannie Mae and Freddie Mac attract an awful lot of hostility from other financial institutions.

In recent weeks, the likes of Wells Fargo & Co., American International Group Inc. and General Electric Co.'s GE Capital unit have amplified longstanding complaints about Fannie Mae and Freddie Mac. Started decades ago by the federal government to make the mortgage market run more smoothly, Fannie and Freddie buy mortgages from lenders and package loans for sale to institutional investors. But Wells Fargo, AIG and GE Capital say that, contrary to their innocuous names, Fannie and Freddie are improperly expanding beyond their original purpose and using bullying tactics to stifle criticism.

The allegations, although made in vague terms, have spurred talk of greater regulation of Fannie and Freddie. For their part, the two mortgage giants deny any improper conduct, and say their main goal is to reduce costs for consumers.

But people in the industry say beneath this public confrontation, a deeper anxiety about Fannie and Freddie haunts financial institutions. The institutions fear that new technology created by Fannie and Freddie threatens to drive many of them out of home lending. Fannie Mae CEO Franklin Raines denies any such intention. "I can't account for paranoia," he says.

For a peek at the dreaded technology, you might visit tiny Northstar Mortgage in this suburb of Washington. Here, in the company's office on the second floor of a townhouse, mortgage broker Richard Muller types a secret code into his computer and gains access to Freddie Mac's closely guarded "automated-underwriting" system. Instead of the mountains of documents once required, he enters minimal information about a client's income, the value of the property being bought and its location. The system pulls up information from credit agencies and uses statistical modeling to predict the likelihood of default. Within minutes, the computer spits out a decision.

Mr. Muller, Northstar's president, still needs a bank to fund the loan. But the bank will either have to pay Northstar for the loan or surrender a significant chunk of the lucrative "origination fee" traditionally charged by lenders. Soon after the deal is signed, the bank probably will sell the loan to Freddie.

Lenders attribute the recent proliferation of mortgage brokers in part to the introduction in the mid-1990s of Fannie's and Freddie's automated-underwriting systems. The online technology, provided for a modest fee, has quietly fragmented the lending business and shifted power to brokers by allowing them to perform some of the services once provided exclusively by banks.

Now, some banks fear Fannie and Freddie are preparing to take a further step: squeezing them out of the loan-making process altogether. According to this scenario, Fannie and Freddie would in effect become lenders themselves, relying on an army of brokers and small mortgage companies -- some of them operating online -- as field agents.

Fannie and Freddie "could literally wipe out the role of lenders," says Keith Gumbinger, a mortgage-market analyst at HSH Associates, a financial publisher.

Banks face a predicament similar to that of travel agents, stock brokers and other traditional middlemen who have watched millions of customers defect to inexpensive online services. Technology can empower new, more efficient competitors. In the mortgage market, it threatens to reduce big lenders to "a shrinking and increasingly irrelevant" part of the industry, says Gary Gordon, an analyst with UBS Warburg.

Unlike traditional banks, with their spacious lobbies and salaried loan officers, Mr. Muller's Northstar is crammed with used furniture and salespeople who work on commission. There isn't even a sign out front. The company shares its conference room with a hardware-distribution company.

Northstar expects to close $120 million in loans this year, up from $20 million in its first full year in operation, Mr. Muller says. "Without automated underwriting, I wouldn't be that competitive."

Fannie and Freddie say their widely used software has increased efficiency and competition and lowered consumer borrowing costs. And, they argue, most of the complaints come from big players whose dominance is threatened. "We can give consumers more choices," says Pete Maselli, a senior vice president at Freddie Mac. "We don't see our role as protecting the turf of anybody, particularly the largest lenders."

Some banks have thrived under the new order, embracing brokers as their partners and saving money on salaried loan salespeople. But over the long run, having more brokers and other small players jostling for market share forces larger banks to compete more vigorously. That cuts into their profit margins and forces weaker competitors to abandon the business -- a process that is now well under way.

Industry veterans say automated underwriting has had another effect: By aiding brokers and diminishing the market muscle of banks, Fannie and Freddie have strengthened their own relative positions. This strengthening comes at the expense of traditional lenders that have resisted selling mortgage loans to Fannie and Freddie. In some cases, banks prefer to keep some of the loans they make, meaning that Fannie and Freddie don't get them.

If brokers armed with automated-underwriting software were allowed to sell loans directly to Fannie and Freddie -- cutting banks out of the loan-making business -- that would make it easier for the two companies to feed their huge appetites for loans. If that happened, the technology could lead not just to greater efficiency and cost-saving, but a radical reshaping of the mortgage market.

Fannie and Freddie officials say they're not planning to cut banks out. But bankers say their fears have been exacerbated in private conversations with Mr. Raines and other executives at Fannie Mae. Mr. Raines has stopped short of predicting the elimination of banks from the mortgage process, bankers say. But he has compared the relationship between Fannie and Freddie and traditional lenders to that of big soft-drink companies, such as Coca-Cola Co. or PepsiCo Inc., and their bottlers -- with banks as bottlers, serving a restricted role, the lenders say.

"I perceive a bottler as a subordinate to the person who makes the syrup," says Angelo Mozilo, CEO of Countrywide Credit Industries Inc., based in Calabasas, Calif., and one of the executives who describe such conversations with Mr. Raines. "After building a company for 32 years," Mr. Mozilo adds, "I didn't like being put in a subordinate role."

Mr. Raines confirms talking with Mr. Mozilo, but he says he meant the cola comparison to illustrate a voluntary alliance he hoped to form under which Countrywide would sell all its loans to Fannie. Mr. Mozilo, whose company has since agreed to sell most of its loans to the company, says he now roughly agrees with Mr. Raines's interpretation of their conversation.

The theme of Fannie's and Freddie's expansion beyond their original mission runs through many of the industry nightmares. The pair of federally chartered organizations evolved over the years into huge publicly traded companies, which in the 1990s dropped long bureaucratic-sounding names and adopted their nicknames. Together, they own or guarantee loans totaling about $2.3 trillion.

By buying loans from banks, the sister entities provide lenders with cash to make new loans. This additional liquidity in the mortgage market has encouraged more home-buying and -building.

Fannie and Freddie have grown steadily, at least in part because of advantages related to their remaining ties to the federal government. These ties, such as small lines of credit directly from the U.S. Treasury, have contributed to a perception among investors that in the event of a financial disaster, the government would bail out Fannie and Freddie. Even though this view isn't grounded in the language of the companies' federal charters, it makes debt issued by Fannie and Freddie more popular with investors, lowering the mortgage entities' borrowing costs.

Some banks and other financial institutions complain about having to compete against companies whose government ties give them an edge. These antagonists have formed a Washington lobbying group, FM Watch, to push for legislation restricting Fannie's and Freddie's role and to monitor their activities.

Companies active in FM Watch have complained in recent weeks that the two mortgage giants have sought to bully them into ceasing such lobbying and criticism. Financial institutions have accused Fannie and Freddie of taking away -- or threatening to take away -- debt-underwriting business from their Wall Street arms. Fannie and Freddie have paid hundreds of millions of dollars in underwriting fees in recent years.

But the institutions haven't provided details of these alleged tactics, saying they fear further reprisals from Fannie and Freddie. Last month, Richard Kovacevich, chief executive of Wells Fargo, said: "Fannie Mae has used its ability to allocate business to the detriment of institutions that have executives on the FM Watch board. I am personally aware of an instance involving our company in which we were removed, without cause, from the list of approved bidders for Fannie Mae bonds." But Mr. Kovacevich declined to elaborate, other than to say the cutoff occurred two years ago.

But meanwhile, another source of concern for some banks is the automatic-underwriting software that Fannie and Freddie have made available to thousands of mortgage brokers. While technological advances are inevitable, says Gerald L. Friedman, chairman of FM Watch, "my resentment is that government-sponsored enterprises are accelerating the process" of making brokers and other small players a threat to larger banks.

Speaking on the condition of anonymity, a senior official at one of the nation's largest mortgage lenders adds that putting automated-underwriting technology in brokers' hands "basically marginalizes the role of a player like us."

The big banks spent millions of dollars developing their own high-tech underwriting systems in the 1990s. But the bank software never caught on widely, in part because it varies from institution to institution. Fannie's and Freddie's versions became the twin standards for the industry, giving the two companies a valuable beachhead in banks and brokers across the country.

Meanwhile, officials with Fannie and Freddie are moving on multiple fronts to boost small and nontraditional providers of loans. Last month, Freddie Mac agreed to offer a $2.5 million line of credit to LendingTree Inc., a still-unprofitable online mortgage broker.

Fannie Mae separately encourages unsecured home-improvement loans made available to buyers of siding, roofing or windows at Home Depot Inc. The retailer takes applications from consumers, Chevy Chase Bank of Maryland funds the loans and Fannie then buys them.

As for brokers, Freddie Mac recently announced a contest to reward top performers. Freddie has pledged to give 10 free trips to Hawaii for brokers who use automated underwriting and "provide outstanding customer service."

Mr. Raines of Fannie Mae says his company aims to increase business with small lenders 20% over the next year. But Fannie isn't trying to squeeze out big banks, he maintains.

The mortgage business began to change in the late 1980s, as brokers and other new players emerged to accept loan applications and then shop them around to lenders. In some areas, brokers have been accused of fraud and other misconduct. But that hasn't slowed their growth. Typically, brokers get about 1% of the value of loans as a fee -- money that comes directly out of the pockets of banks.

Hard statistics are sparse, but industry experts estimate that brokers now originate more than 50% of all home loans, up from about 20% in the early 1990s. There are about 25,000 mortgage brokers in the U.S., according to Wholesale Access, a research firm.

Brokers using automated underwriting at Leader Mortgage Co. in Lenexa, Kan., say they close loans in as few as three days, compared with about a month in the old days. Employees of Pirimar Home Loans in Indianapolis even make house calls, using lap-top computers to approve loans.

Northstar's Mr. Muller compares as many as 15 rate sheets each morning, faxed to him by banks across the country. He promises to find customers the best deals available and charges fees he says are sometimes lower than those charged by banks. "A small businessman," he says, "can run his business a lot more cheaply than a big bank with 11 vice presidents."

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