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Wednesday, July 15, 2009

How Fannie Mae and Freddie Mac Crashed An Economy

Much has been written and spoken about the housing crisis that led our economy into the current recession. Finger pointing abounds and victims and villains are presented to be cuddled or hounded. Early on the media attacks went after the easy targets, swarmy mortgage brokers, greedy Wall Street brokers, etc. I touched on this in my post last week "Curing The Foreclosure Crisis". One major factor in the housing market collapse that has not been mentioned in any reports or stories that I have read is the use of Automated Underwriting Systems (AUS) by Fannie Mae and Freddie Mac and their contribution to an industry writing weaker and weaker loans.

Automated Underwriting Systems came into the mortgage industry in the late 1990's. Fannie and Freddie in an effort to streamline their processes, facilitate the transfer of mortgages from originators to lenders to the GSEs (Government Sponsored Entities: Fannie and Freddie are both private companies with government charters, they can make a profit but are regulated by Congress), and to have their mortgages more uniform in their approval processes, conditions and evidence required for purchase and sale as Mortgage Backed Securities.

To perhaps further your understanding a very quick overview of the path of a mortgage: a mortgage application is taken by an originator, the application package is approved by a lender and if all the conditions are met it is funded, the loan package including the note and grant deed or mortgage depending on state is forwarded to the lender, the lender puts the loan package into a bundle with tens of millions of other mortgages and the bundle is sold to one either Fannie or Freddie depending on how it was underwritten, Fannie or Freddie then bundle this bundle with other bundles and has an offering for investors of bonds or securities, an investor can purchase an investment in Mortgage Backed Securities and receive interest payments and repayment of principal as the mortgagees pay their monthly payments and pay off their mortgages. Someone in Iowa can and does invest in a bundle of mortgages from Wyoming, Hawaii, Vermont, etc.

In the old days....before the advent of the Automated Underwriting Systems in the late 1990s those of us in the mortgage industry used age old methods of obtaining loan approvals for clients. We would meet with the client and fill in an application package by hand, collect W2s, tax returns, paystubs, bank statements, letters of explanation for any blemishes on the credit report and what ever else we felt the clients financial profile needed. We would package these items with an appraisal, title report, credit report and send them to an underwriter. The underwriter would open the file, review all the paperwork we had submitted, and if we did our job correctly would approve the loan for funding using the credit policies and guidelines of Fannie, Freddie, FHA or VA. Every file had proof of income, assets and explanations from the borrowers for any credit dings.

Seeing that perhaps this process could be streamlined and made more efficient using emerging technology, the GSEs developed their AUS, Fannie Mae rolled out Desktop Originator/Underwriter and Freddie Mac brought Loan Prospector to market. Now instead of sending a complete loan package for approval, an originator could input the loan application information into the software program and the program would analyze the data against the guidelines and issue an approval or decline. If the application received approval it would detail what items would needed to be submitted with the loan for final approval and in order for the GSE to purchase the mortgage from the lender (see steps above in the path of a mortgage). We might input the information for a borrower and receive an approval that requires a paystub, most recent year W2, one month of statements to verify funds for closing and reserves and a credit report. Having experience in the industry we knew that borrowers need to have income to debt ratios no higher than 40-42% (percentage of gross income for current debt obligations like credit cards and auto payments plus the new housing obligation).

As with all technology the more it was used the more efficient it became. By 2002 every lender was requiring an AUS approval on loans before they would fund conventional mortgages for sale to GSEs, this happened because the GSEs were requiring an AUS certificate in order to purchase the loans. No more traditional underwriting. So if the AUS approval required one W2 then the underwriter would call for one W2, if the AUS approval called for no W2 and only a paystub then the underwriter would call for only a paystub and no W2. The more transactions and mortgages funded throughout the country with the AUS approvals the more tracking history the system had for credit defaults and foreclosures under certain credit profiles and the more the system was able to adjust documentation requirements for loan approvals. Problem is during this period when the AUS were becoming more and more prevalent in the loan underwriting process, early 2000s on, the economy was starting to grow and home prices started rising--fewer foreclosure risks as troubled borrowers found they had equity and could sell their homes.

Around 2004-2005 we saw a dramatic change in the AUS approvals, coinciding with lenders offering 2nd trust deeds to 100% of the total value of the property. The industry had been using second mortgages to bridge ten percent down payments to reduce the amount of the first or primary mortgage below the magic 80% value level to avoid mortgage insurance, now the lenders with approval from Fannie and Freddie were offering second mortgages covering the entire down payment. As these mortgage products became more prevalent in the industry we saw a loosening, a significant loosening, of the credit guidelines from the GSEs. Because of the purchase agreements between the lenders and the GSEs, if the Automated Underwriting System approved a loan and the lender supplied the documentation required by the AUS then the loan would be purchased.

By this time the technology had advanced to the point that the industry software developers integrated origination processing software, credit reporting companies and the GSEs software so that within fifteen minutes I can complete the necessary information on a loan application, pull a credit report with all three major agencies, submit the information to Fannie Mae and receive an approval listing what items I would need to fund the loan. And the list of those items became less and less. As the credit guidelines from the GSEs became easier and easier more people could qualify to purchase a home. Many originators and lenders were not analyzing whether it made sense for a family to purchase the home they were buying based on their actual financial ability, but rather were inputting information into the AUS to get an approval and close the loan. And houses flew off the market. Borrowers would shop originators to find one that would approve them. Real estate agents knew which originators were "loose" and which were more strict and analyzing and refer accordingly. Borrowers, originators, agents, all over the industry with prices exploding people were chasing homes and commissions, and they were aided and abetted by Fannie and Freddie.

At the height, or depth, of the loose guidelines it was astounding the mortgages being approved through Fannie and Freddie. Borrowers with no money down, a seller paying closing costs and little to no reserves would be approved and the approval would require no income verification, merely a phone call to the employer to verify the applicant was still employed, no verification of assets and NO appraisal! Yes, the AUS technology evolved to the extent that they also included sales data and for most areas the system would pull comparable closed sales and if the price on the application was within the market range no appraisal, or perhaps a drive-by to make sure the house was there, would be required.

Further with no income verification borrowers with income to debt ratios in excess of 60% (sixty percent) would be approved; this means for a family they would have 40% of their gross income after paying their mortgage payment, car payment(s), student loans and credit cards to pay for shoes, groceries, electricity, income taxes...Applicants with below median FICO scores and no downpayment would be approved with verbal verification of income and no assets--individuals who have shown a history of difficulty managing their credit obligations would be given loans for a home in which they had no equity stake. Oh, and one more thing most of these loans were interest only mortgages with the interest only payment used for the qualifying guidelines--no equity at closing and no equity in the mortgage payments.

As the technology and the efficiency it allowed became more ingrained in the system lenders on "jumbo" mortgage products--those with loan amounts above the Fannie and Freddie guidelines--also used the AUS approval findings for their mortgage products, expanding the loose standards through more of the mortgage products being funded. Lenders on second trust deeds and home equity lines of credit also jumped on the AUS bandwagon--the entire industry was basing their approvals and fundings on the ever loosening guidelines established by Fannie Mae and Freddie Mac. Guidelines we know were loosened at the behest of Congress and in particular the two most vocal and ardent supporters of Fannie and Freddie Rep. Barney Frank from New York and Senator Christopher Dodd from Connecticut. Their desire to expand homeownership down the income and economic scale so more Americans could participate required looser and looser credit standards to fit those with below median incomes into a housing market where the median prices were soaring.

All of these mortgages were approved by the Automated Underwriting Systems, guaranteed for purchase by Fannie Mae and Freddie Mac and sold to investors as Mortgage Backed Securities. Well to no surprise when the credit markets tightened with the first domino being a sub-prime lender failing to obtain credit on Wall Street, investors began to look at their mortgage portfolios and those who held securities backed by Fannie Mae and Freddie Mac approved mortgages began to see that what they were invested in were actually sub-prime mortgages packaged as conventional, traditional mortgages. Uh-oh. What investors and investigators found was what those of us in the industry knew--a tremendous percentage of the "conventional" mortgages funded were actually sub-prime mortgages packaged by Fannie and Freddie as "A+" paper approved by either Desktop Originator or Loan Prospector.

Fannie Mae and Freddie Mac, and their leaders through the time period, have not received near enough credit for their role in the housing and credit crisis that began in 2007. An overwhelming number of foreclosures on the market are loans that were funded under Fannie and Freddie guidelines with AUS approvals. An overwhelming number of foreclosures had no down payment when purchased, or were refinanced up to or over 95% of the then value of the home using AUS approvals. If every mortgage for every home that has been foreclosed upon or is currently going through foreclosure is analyzed one would see that every one that was a Fannie or Freddie mortgage has an AUS approval in the file and the documentation matches what the approval called for when it funded: verbal verification of employment, drive-by appraisal, nothing more.

Congress is big on investigating, or threatening to investigate, their political enemies or those who they feel will make for good television (think of the baseball steroid hearings). If Congress truly wanted to investigate what led to our current economic cycle that was started by a collapse of the credit and housing markets they should start with a detailed investigation of Fannie Mae and Freddie Mac and who was responsible for loosening credit guidelines to the extent they were loosened. Until they do this, any measures or policies they impose, any statements they make laying blame on others, any investigations they do of any part of the industry that is not Fannie or Freddie is grandstanding. But we know that is what those in Washington do best.


1 comment:

Anonymous said...

From the beginning...
Clinton gave the nod for this if I remember correctly