have begun to address mortgage underwriting practices that helped lead to the credit crisis, even as Congress wrestles with bigger questions about the future shape of the mortgage giants.
Freddie Mac, the smaller of the two government-sponsored enterprises placed in conservatorship by federal authorities last month, recently informed banks and thrifts that it will stop buying stated-income, or so-called Alt-A, mortgages early next year. These loans carry more risk because borrowers have not documented their ability to repay them. But Fannie and Freddie continue to purchase other loans with special risks, such as mortgages with down payments financed by second mortgages, also known as "piggyback" loans.
The government is mulling how to structure the GSEs going forward, with options ranging from allowing them to continue as government agencies or privatize them and splitting them up.
Chairman Ben Bernanke on Friday said some form of federal backing of the two companies would probably be necessary.
Either way, Congress must address two key problems:
- The notion of private profit (with fat bonuses for executives, along with a nice growth rate and dividends for stockholders) and public risk, in the form of an implied guarantee on securities issued and guaranteed by Fannie and Freddie. The implied guarantee lowered GSE funding costs, which was great for shareholders. Federal regulators failed to require the mortgage giants to hold sufficient capital, which we now see was terrible for taxpayers.
- While Fannie's and Freddie's prime business is guaranteeing the payment of mortgage interest to investors, their balance sheets are mainly comprised of investments in mortgage-backed securities. So in a weak real estate market, the GSEs not only suffer from making the guarantee payments to investors, they take massive losses in their investment portfolios.
A First Step, but a Ways to Go
Freddie Mac last week informed seller/servicer banks and thrifts that it would stop buying stated-income mortgages, effective Feb. 2, 2009. A stated-income mortgage is one where the loan underwriting does not require the loan applicant to document their income.
Nonperforming Alt-A loans, along with insufficient capital reserves, were major factors in the troubles that led the Federal Housing Finance Agency to place the two government-sponsored enterprises into conservatorship on Sept. 7. Fannie Mae had already announced on August 8 that it would wind down its Alt-A business.
Meanwhile, Freddie and Fannie continue to purchase first mortgages that feature piggyback second mortgages that finance the down payments.
Mortgage lenders and secondary market loan purchasers like Freddie Mac and Fannie Mae, traditionally had required borrowers to put down 20% when purchasing homes or have less than an 80% loan-to-value ratio when refinancing. That 20% provided the lenders a decent cushion in the event of falling home values. Freddie and Fannie required borrowers who didn't make 20% down payments to purchase private mortgage insurance to cover the lender in the event the loan went sour and the foreclosed property had dropped in value.
During the real estate boom, lenders started offering piggyback second mortgages to finance down payments and avoid private mortgage insurance. Then Fannie and Freddie began purchasing some of these first mortgages, even though they violated the government-sponsored mortgage-buyers' original down payment requirements.
So why keep buying them now?
"There's only one element that's going to stabilize housing, and that's buyers," says Jim LeBaron, senior director of international business advisory firm BBK. "We'll need to remain flexible."
So, in keeping with their mission to support housing, the GSEs are continuing to buy first mortgages with piggyback second mortgages. Freddie and Fannie can still securitize a first mortgage with a loan-to-value ratio of 80% or less, and can mitigate their risk by tweaking the down payment requirements a bit.
For example, there may be a combined loan-to-value ratio of 90%. So a home is purchased with a down payment of 10%, a piggyback second finances 10% and Freddie or Fannie purchases the 80% loan-to-value first mortgage, which can be securitized.
In order to better cover the credit risk associated with mortgages with secondary financing, Freddie Mac is increasing its delivery fees for these loans, effective Jan. 2. For a typical amortizing fixed-rate mortgage following our 90/10/10 example, the fee would amount to an extra .0625 of a percentage point for a borrower with a credit score below 720. There is no fee for fixed-rate borrowers with credit scores of 720 or better.
So, if the first mortgage was $200,000 and the rate increased from 6.00% to 6.0625%, that would be an extra $8.04 per month, or $2,897 over the life of a 30-year mortgage.
Future of Freddie and Fannie
There are many ideas being bandied about regarding the future of the GSEs, including keeping them as government agencies (and wiping out stockholders), having them continue as publicly held companies with restrictions to try and prevent another disaster, or splitting up the companies along business lines and selling off the pieces as new, private companies with no government backing.
Lost in the discussions is the fact that Freddie and Fannie are "really insurance companies, acting as hedge funds," says George Oldenfield, principal at the Brattle Group and former managing director in securitization at Paine Webber, who also has experience at the
Securities and Exchange Commission
, specializing in financial derivatives, asset- and mortgage-backed securities and risk management.
While Freddie and Fannie keep some mortgages on their balance sheets, especially the ones that don't meet their securitization guidelines, they don't own most of the mortgages they guarantee. When setting up a securitization program, a GSE sets up a separate trust, which issues the mortgage-backed securities. Freddie and Fannie then provide guarantees that mortgage interest payments will be made to the trusts, which in turn pass the interest through to investors.
Dealers who buy the Freddie and Fannie pass-through securities from the trusts will in turn put them into new trusts, called real estate mortgage investment conduits (REMICs), from which they can slice and dice interest streams from the GSE paper and issue the collateralized mortgage obligations (CMOs) that have come to symbolize the dangers associated with derivative securities.
Since the heart of Freddie's and Fannie's business is to guarantee that interest payments are made to the trusts, they are essentially acting as insurance companies. The trouble with this business model, according to Oldenfield is that, unlike actual insurance companies, Freddie and Fannie haven't built up insurance reserves (or sufficient capital), which of course has made them appear very profitable.
The GSEs have then compounded their risk by focusing their investment strategies in the same industry they insure, with Investments in mortgage-backed securities comprising the bulk of their balance sheets. An insurance company focusing on one industry would never be allowed to only make securities investments in the same industry.
Hopefully, Congress will address this risk-management issue as they ponder the future course of the mortgage giants.
A spokesman for the House Financial Services Committee didn't immediately respond to requests for comment. Neither the Obama nor the McCain presidential campaigns responded to requests for comment on the future state of Freddie Mac and Fannie Mae.
Oldenfield says Freddie and Fannie will probably go back to operating in a similar way they did before they were taken over by the government.
"The GSEs were always congressional lapdogs," he says. "Congress wrote the charter and approves the regulators."
Frank Mayer III, an attorney with of Buchanan Ingersoll & Rooney specializing in advising companies on relationships with governments and government agencies, expects Freddie and Fannie to remain part of the federal government, "folded into an FHA
Federal Housing Administration-type organization."
As private, responsible competitors to Freddie and Fannie develop, the government can then look to slowly get out of the housing business, he says, adding, "I see a long horizon for that."
Mayer agreed that there were some conflicts in the GSEs' business model and urged quick action by Congress in the face of a "serious emergency now in the regulatory scheme."
"Confusion hurts the markets, so hopefully Congress will reach across the aisles and set up a regulatory regime as soon as possible," he says. "I am optimistic."
Philip W. van Doorn joined TheStreet.com Ratings., Inc., in February 2007. He is the senior analyst responsible for assigning financial strength ratings to banks and savings and loan institutions. He also comments on industry and regulatory trends. Mr. van Doorn has fifteen years experience, having served as a loan operations officer at Riverside National Bank in Fort Pierce, Florida, and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a Bachelor of Science in business administration from Long Island University.