A government watchdog on Wednesday said Fannie Mae and Freddie Mac's regulator needs to curtail the rising cost of their legal expenses since there is no end in sight to the widening taxpayer tab keeping the two firms afloat.

Fannie Mae and Freddie Mac are spending tens of millions of dollars to cover the legal costs of former executives who face various private, class-action lawsuits and government investigations, according to the report.

The overseer of the two firms, the Federal Housing Finance Agency, needs to limit litigation costs, the agency's inspector general said in the report.

FHFA agreed to pay to defend the agencies and former officers when Fannie Mae and Freddie Mac were taken over by the government in 2008, and they have yet to cut off funding for the mounting legal bills.

FHFA must continue its efforts to both control and scrutinize these legal expenses now and in the future, Steve Linick, inspector general of the finance agency, said in a statement.

From 2008 through 2011, Freddie Mac has advanced about $10.2 million for legal representation of its officers and directors, according to the report. The expenses are significantly larger at Fannie Mae.

The watchdog's report cited three of Fannie Mae's former top executives as absorbing a bulk of the firm's legal expenses. Franklin Raines, its former chief executive; Timothy Howard, its former chief financial officer, and Leanne Spencer, the former controller, racked up $99.4 million in Fannie Mae legal expenses between 2004 and 2011.

SAVINGS SEEN

Internal reviews at Fannie Mae have already uncovered some areas where legal fees could be reduced, according to the watchdog's report.

An outside auditing firm reviewed Fannie Mae's legal bills and recommended about $12 million in reductions, which is about 17 percent less than the total $73 million that was billed from March 2007 to 2011 by law firms representing Raines, Howard and Spencer.

Freddie Mac has implemented a set of billing guidelines for the law firms it works with, the watchdog found, which has helped reduce advances paid on the behalf of directors and officers by about 3 percent since the firm was taken over by the government in 2008.

Accounting problems arose at Freddie Mac before the 2008-09 credit crisis erupted and the company was found to have understated its income from 2000 to 2002. In 2004, Fannie was also found to have massaged its results for the preceding six years and had to revise its past earnings downward.

The FHFA has been involved in a number of lawsuits filed against major financial institutions for mortgage-backed securities sold to Fannie Mae and Freddie Mac during the housing boom.

In order to limit the scope of future legal contracts with Fannie Mae and Freddie Mac, FHFA needs to use new methods, including finding a way to cap the total amount of legal expenses it expects to pay for officials and directors, the watchdog recommended.

The recommendations also include raising insurance premiums in order to save money on any possible future lawsuits, and developing new standards for legal billing practices.

The high cost of legal fees for the two firms gained the attention in February 2011 of the House Financial Services Committee, which requested details on the legal bills from the

FHFA.

For the most part, FHFA agreed to the inspector general's findings. The FHFA said it would take new steps to pay closer attention to future indemnification agreements, in a written response which accompanied the report.

Fannie Mae and Freddie Mac have cost taxpayers about $169 billion to stay afloat.

Both firms are searching for new chief executive officers after it was announced the current bosses are leaving this coming year. FHFA has said it is necessary to cover legal expenses for Fannie Mae and Freddie Mac CEOs in order to attract and retain its skilled work force.

(Reporting by Margaret Chadbourn, Editing by Gary Crosse)

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