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Wednesday, January 13, 2010

Hall Pass

In the past few days I have been sent links, articles and found on my own several articles and opinion pieces on the housing/mortgage crisis, Fannie Mae and Freddie Mac. In particular was a piece from my Dad from the Wall Street Journal, "The Fed Crisis: A Reply to Ben Bernanke" (subscription may be required), by John B. Taylor who created the "Taylor Rule". The Taylor rule is a model by which central banks can determine whether to increase or decrease rates and by how much. Taylor takes Bernanke and the Fed to task claiming the primary factor in the housing crisis was rates that were too low and created an expanding housing bubble with really cheap credit.

Bernanke is being grilled in the media and on Capitol Hill regarding rates and how Fed policy in the early to mid-2000s created the housing bubble and ultimate crashes of housing, mortgage and credit industries. In reading these articles and opinions one thought kept resonating with me: Fannie Mae and Freddie Mac are getting the biggest hall pass in economic history by a majority of politicians, media and pundits.

Sure Fannie and Freddie are taking some heat now for huge bonuses being paid to executives, for essentially unlimited credit from the Treasury after being given lines of credit in excess of $100 billion each, but the roles of Fannie and Freddie in the housing and credit crisis is being deflected to blaming low interest rates. Sure low rates were a factor, but from the inside of the business I still assert not the factor. Low rates expand the availability of credit, loose underwriting standards explode the availability of credit.

In July I wrote about the Automated Underwriting Systems (AUS) of Fannie Mae and Freddie Mac (How Fannie Mae and Freddie Mac Crashed An Economy) detailing how the systems work. For those who missed it, don't remember it or do not want to read about it here is a summary. Essentially starting in late 1990's Fannie/Freddie developed software that would read mortgage application packages and provide loan approvals that lenders would follow. As more and more mortgages went through the system they had statistical ability to read foreclosure and default data and tweak the guidelines. Of course from 2000-2007 there were almost no foreclosures because housing prices increased and anyone in trouble could pretty much sell and get out of it--or get a sub-prime loan from New Century or other lender.

As we headed into 2005 and 2006 the guidelines became so loose that we would see loan approvals for borrowers with debt-to-income ratios of 65% of their gross income, for 100% financing. That means a borrower could have dedicated 65% of their gross income for their mortgage payments, property taxes, hazard insurance and any debt such as credit card payments, auto loans, student loans, etc. That would leave 35% of their gross income for state and federal withholdings and taxes, health insurance premiums, retirement contributions, clothing, entertainment, food, gas, water. Further, many of these approvals did not require full verification of income.

I stand very firm in stating that this, the loose standards of Fannie and Freddie, were far more contributory to the housing bubble and ultimate collapse than low rates. Let me provide and example using real numbers from 2005 and real numbers from 2010. First, note that in December Fannie Mae tightened criteria for lending to require a minimum FICO score 640 for purchase transactions (680 for cash out refinances) and a hard debt-to-income limitation of 45% of adjusted gross income.

In looking at interest rates from 2005, the were higher than they are today spending most of the year above 5.5% for 30 year conventional (Fannie/Freddie) fixed rate mortgage. Prior to 2005 rates hit 5% or came close, but never pierced the 5% barrier. Since December 2008 rates have been consistently below 5%.

For my example I am going to use a borrower making $63,000 per year, or $5250 per month. I am going to assume the borrower has a debt load of 10% of gross income--about average for most borrowers.

In 2005 this borrower would have had available 100% financing using "piggy-back" financing with a 1st trust deed covering 80% of the sales price and a 2nd trust deed (usually a home equity line of credit) for 20% of the sales price. Both mortgages would be approved using the Fannie Mae Desktop Underwriter. Both mortgages would be underwriting using interest only minimum payments for qualifying. The interest rate on the first would be 5.5% and on the second 6.5%.

This borrower would have been approved and funded for the purchase of a $500,000 home. The interest only payments on the two mortgages would be $2800 per month, over 50% of the borrowers gross income with taxes, insurance and every other expense still left to be paid with the remaining $2450 of gross income.

Flash forward to January 2010 with the same borrower. Today there is no piggy-back 100% financing available, so at a minimum the borrower will need 5% down payment. The interest rate on the 1st will be 5% and the borrower will have to pay for private mortgage insurance.

In 2010 the same borrower making $63,000 per year qualifies for a purchase price of $260,000. Same borrower, same income, debt, credit record and a lower interest rate and he qualifies for $240,000 less in home value. Oh, and the borrower needs $13,000 for down payment.

The largest contributing factor to the housing bubble was not low interest rates, it was low qualifying standards set forth by Fannie Mae and Freddie Mac. Qualifying standards that got looser and looser as the decade progressed until finally the system collapsed starting in 2007.

Further contributing to the financial mess was that Fannie and Freddie would package the 2005 borrower with the loose underwriting standards as an "A paper" loan and sell it on the secondary market as such. Investors were purchasing billions of dollars of Fannie and Freddie mortgage backed securities where the investment was in fully leveraged borrowers with debt to income ratios exceeding 50% of their gross income. Because they were sold as A-paper, or prime, mortgages there was little risk associated compared to the sub-prime mortgages that are blamed for collapsing some financial houses. In fact the Fannie and Freddie mortgages were as risky as those labelled and securitized as "sub-prime." Will there be any lawsuits from investors?

While certainly not every loan in the Fannie and Freddie portfolios from the period had debt to income ratios up to 65% many did; and a significant amount of the portfolios had borrowers with debt to income ratios in excess of 50-60%. With everyone wanting to be a homeowner as prices started to spike Fannie and Freddie underwriting criteria loosened seemingly in proportion to demand. Lesser and lesser qualified borrowers were buying homes with higher and higher prices.

Interest rates do not account for being able to qualify for almost twice as much loan and home value for the same borrowers, underwriting criteria do. Every time I hear someone opining on the Fed and low interest rates as the cause of the housing bubble I shake my head, knowing that someone is taking blame and someone is avoiding blame for the root cause of the housing price run up. The proof is in doing the math using the guidelines of the period.

I will repeat, Fannie Mae and Freddie Mac have gotten the biggest hall pass in economic history from politicians, media and pundits. Until they are put under investigation and their underwriting standards examined and questioned they will continue to be over-looked for their contribution to the housing bubble and crisis.


Charles S said...

But Dennis, it was the Community Reinvestment Act of 1977 that led to the lowering of credit standards, right?

Dennis C Smith said...

Charles: While Congress, particularly Rep Frank and Sen Dodd's committees, pressured Fannie/Freddie to loosen underwriting criteria the ultimate deed was done by Fannie and Freddie. As well Fannie/Freddie are the ones who packaged the funded mortgages as "prime" despite having tremendous amounts of high debt-to-income ratio borrowers in the portfolios.

From the origination side what we saw from the Community Reinvestment Act (CRA) loans were specific census tracts that were CRA eligible in which lenders would pay premiums for loans in those areas. The eligible census tracts were based upon median incomes in the census tracts compared to median incomes in the county where located. All properties were eligible, even investor purchases. As a result many brokers/originators concentrated business in those areas because of the lender premiums, that were intended to pass through to borrowers in lower rates but for many ended up on the commissions paid to the originator. Because the CRA eligible tracts were income based we saw some interest anomolies, such as huge parts of Palm Springs/Desert that were eligible because despite the wealth in the area the reported incomes were very low due to fixed income pensions and social security.

CRA impulses did not hit our industry significantly until Clinton's 2nd term. The guidelines I addressed coincided much more with the advent and progression of the AUS software used to approve mortgage applications.

Thanks for your comments, as always!