In a report to be issued on Tuesday, the inspector general for the Federal Housing Finance Agency urges the regulator to ensure Fannie Mae applies more scrutiny to the pricing of such transactions and possibly revise its contracts with mortgage servicers.

"FHFA should ensure that Fannie Mae does not have to pay a premium to transfer inadequately performing portfolios," the report says, referring to the regulator of Fannie Mae and sibling Freddie Mac.

The watchdog, however, called the effort to shift troubled loans to companies more skilled at working with borrowers a "promising initiative" that could reduce loan losses for government-controlled Fannie Mae and taxpayers. It could also reduce foreclosures.

The FHFA inspector general scrutinized the $512 million payment Fannie Mae agreed to make to Bank of America in August 2011 after members of Congress asked for a review. Some critics viewed the deal as a back-door bailout that allowed the second-largest U.S. bank to shed poor-performing mortgage loans - and get paid for it.

At issue is a program in which Fannie Mae sought to reduce losses on troubled loans by bringing in specialized firms to handle payment collection and loan modifications.

Banks make mortgages and sell them to Fannie Mae and Freddie Mac, which package them into securities for investors. Mortgage servicers such as Bank of America, however, continue to administer payments sent in by borrowers. Fannie Mae can shift loans handled by one servicer to another, but has to pay a termination fee to do so if the move is deemed "without cause."

In January 2011, Fannie Mae started discussions with Bank of America about buying the mortgage servicing rights to 384,000 loans with an unpaid principal balance of about $74 billion, according to the report.

Fannie Mae had projected losses of about $11 billion on the loans, but determined it could get savings of up to $2.7 billion by transferring them to another servicer. Fannie Mae concluded that the bank's overall service was below average compared with its peers, but it had not determined the bank to be in breach of its contract, according to the report.

Eventually, Fannie Mae agreed to pay a termination fee of $512 million to Bank of America, about $85 million more than it had to under its contract, according to the report. The bank had balked at a lower price and would have been allowed to delay the sale for up to three months as it sought another buyer.

At the time, the FHFA reviewed the deal and was concerned about the premium, according to the report. The regulator had previously raised concerns about similar transactions, determining Fannie Mae "routinely paid more than the contractually specified fee for terminations without cause."

In a July 2011 email, one FHFA official wondered whether Fannie Mae squeezed Bank of America hard enough on price considering the bank was benefiting by "getting this stuff off their books." In an email to FHFA, Fannie Mae argued it agreed to pay the premium for a number of reasons, including avoiding possible lawsuits with the bank, according to the report.

Ultimately, the regulator did not object to the sale after Bank of America agreed to refund about $70 million of the purchase price if Fannie Mae did not realize sufficient savings from the deal. When all transfers were completed, Fannie Mae ended up paying a total of $421 million to the bank because of a reduction of the number of loans in the portfolio.

FHFA WILL REVIEW

In its report, the inspector general found that the concept behind the program - to reduce credit losses - was "essentially sound." But it agreed with an internal Fannie Mae audit that raised questions about controls on the program. For example, Fannie Mae relied on a single contractor to come up with prices for most of the transactions.

The amount paid to the bank was similar to earlier deals, which carried an average premium of about 15 percent, according to the report. Since the Bank of America transaction, Fannie Mae has not made any more payments to transfer mortgage servicing rights, the inspector general found.

In a response included with the report, FHFA agreed that Fannie Mae should not pay excessive premiums to transfer poorly performing portfolios. The regulator said its supervision of Fannie Mae has and will continue to include reviews of the process for determining the price of "significant portfolio transfers."

The FHFA inspector general issued a report last week that also stemmed from a Bank of America agreement with one of the U.S. mortgage finance companies.

The watchdog found that Freddie Mac will recover up to $3.4 billion more from banks after it began to better scrutinize soured loans for defects that could require banks to buy back the mortgages. The stepped-up loan reviews came after the inspector general raised questions last year about a settlement Freddie Mac reached with Bank of America to resolve mortgage repurchase claims.

The Charlotte, North Carolina-based bank has struggled with mortgage losses after buying subprime lender Countrywide Financial in 2008.

(Reporting By Rick Rothacker in Charlotte, North Carolina. Editing by Andre Grenon)

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