Freddie Mac ( FMCC), the U.S. government-controlled mortgage financier, used flawed procedures for determining how lenders repurchased soured loans, probably saddling taxpayers with billions of dollars in losses, according to a federal audit to be released Tuesday.

The report found the company was ignoring foreclosure trends for loans it purchased from lenders during the housing boom. The revelation could lead to increased requests to put loans back to originators such as Bank of America ( BAC), which is struggling under the weight of such demands from Freddie, its sister agency Fannie Mae ( FNMA), private investors and mortgage insurers. BofA told investors earlier this year it was mostly through claims from Freddie Mac and Fannie Mae.

Freddie, like Fannie, purchases mortgages from originators for either its own portfolio or for inclusion in mortgage-backed securities it sells to investors. When those loans default, the twin mortgage giants can require lenders to buy them back at face value.

But Freddie Mac focuses on loans that sour within the first two years, even though most mortgages originated during the 2005-07 period default in the third until the fifth year, according to the Federal Housing Finance Agency Office of Inspector General.

About 300,000 loans made from 2004 to 2007 that went into foreclosure, with an unpaid principal balance of more than $50 billion, have not been reviewed by Freddie Mac, the auditor said, meaning the company "could be passively absorbing billions of dollars in losses" from loans it rightfully could be forcing lenders to repurchase.

These allegedly deficient practices could have hurt taxpayers in Freddie Mac's January agreement with BofA to settle potential repurchase claims related to 787,000 mortgages.

Over a six-month period before the settlement, a senior examiner at Freddie Mac's regulator, the FHFA, regularly warned about a dozen superiors, including the agency's acting director Edward DeMarco, that Freddie was using a faulty methodology to review defaults eligible for repurchase requests.

At one point, the auditor warned that Freddie was ignoring some 93% of foreclosures from loans made in 2005 and 2006, "eliminating any chance to put ineligible loans back to the lenders from those years".

FHFA ignored the examiner's recommendations, declining to conduct its own review of defaulted loans or forcing Freddie Mac to revamp its processes. The agency eventually approved the BofA settlement, which netted Freddie Mac more than $1.3 billion.

Freddie Mac, for its part, also disregarded the examiner's findings, in part because it did not want to ratchet up such reviews and the attendant repurchase claims they would generate for fear of alienating business partners.

FHFA examiners and Freddie's internal auditors raised questions over the BofA deal, with one commenting that the proposed settlement amount was "too low".

The BofA deal primarily covered loans made by Countrywide Financial, the subprime specialist BofA acquired in 2008. The report noted that Countrywide loans were 50% more likely to violate Freddie Mac's standards compared with other lenders. Thus, its loans were prime candidates for further review and putback claims, adding further to concerns that taxpayers lost money in the BofA settlement.

This June, Freddie Mac's internal auditors found that 85% of loans made in 2005 that ended in foreclosure entered that stage in the third year. Such loans were rarely reviewed for possible repurchase claims. The auditors deemed the company's controls over the repurchase procedure "unsatisfactory." A top manager told Freddie Mac's board of directors that it could recover "several billion additional dollars" by reviewing more loans for possible violations of Freddie Mac's standards.

Freddie Mac declined to comment. FHFA said it continues to stand by its decision approving the settlement. Both told the inspector-general they were reviewing their current procedures.

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