The credit crunch showed few signs of abating going into 2008, and threatened to magnify the housing downturn by adding more foreclosed homes to already bloated inventories and making it impossible or too costly for many would-be home buyers to obtain a loan.

While dozens of mortgage lenders stopped making loans or went out of business in 2007, a bigger problem for many borrowers has been the tightened underwriting standards rushed into place by lenders who remain.

The credit crunch showed few signs of abating going into 2008, and threatened to magnify the housing downturn by adding more foreclosed homes to already bloated inventories and making it impossible or too costly for many would-be home buyers to obtain a loan.

While dozens of mortgage lenders stopped making loans or went out of business in 2007, a bigger problem for many borrowers has been the tightened underwriting standards rushed into place by lenders who remain.

Interest rates on “vanilla” fixed-rate, conforming loans of $417,000 or less made to borrowers with good credit dipped briefly below 6 percent at the end of 2007, and could continue to fall in 2008. But borrowers with less-than-stellar credit, if they are able to obtain financing at all, are paying higher rates and fees, reducing their buying power.

Those paying more to borrow include not only first-time home buyers who can’t scrape together the 20 percent down payment for a conventional conforming loan, but also families looking to trade up to a home requiring a jumbo mortgage that exceeds the $417,000 conforming loan limit.

The cost of private mortgage insurance — required by most lenders on loans with less than a 20 percent down payment — is going up, even for borrowers with credit scores considered well above subprime.

Government-chartered mortgage financers Fannie Mae and Freddie Mac have increased surcharges for borrowers with credit scores below 680, well above the 620 threshold sometimes used to define subprime borrowers, and will require down payments of at least 5 percent on all loans in “declining markets.”

Freddie Mac summarized the new underwriting policies being implemented by both government-sponsored enterprises (GSEs) in a Nov. 15 bulletin to lenders.

Thanks to turmoil in the credit markets, the GSEs — which own or guarantee $4.7 trillion in mortgages, or about 40 percent of outstanding residential mortgage debt — were able to boost their market share to more than 60 percent in the third quarter of 2007.

But while some in the housing industry hold out hope that Congress will give Fannie and Freddie even more leeway to purchase or guarantee loans in 2008, both companies ended up in the red during the third quarter of 2007, and were bumping up against minimum capital requirements and caps on their loan portfolios that could limit further expansion.

That’s a worrisome development, because Wall Street investors who backed many of the risky mortgage loans made during the housing boom have, for the most part, lost their enthusiasm for loans that aren’t eligible for repurchase by Fannie and Freddie.

Since credit markets seized up in August, the secondary markets for subprime and alt-A loans have virtually disappeared, and even corporations have had trouble getting investors to back short-term “commercial paper” debt that was once the lifeblood of many mortgage lenders.

The Federal Reserve has tried to stimulate borrowing by cutting short-term interest rates and increasing the supply of money that’s available to banks. But some say the Fed didn’t move fast enough, and that the magnitude of the credit crisis could be beyond its power to address.

Bill Gross, managing director of Pacific Investment Management Co. LLC (PIMCO), thinks the Fed will have to cut the overnight federal funds rate to 3 percent or lower in 2008 in order to prevent housing prices from falling 15-20 percent. That would help push the rate on 30-year fixed-rate mortgages to between 5 percent and 5.5 percent, allowing “reflation” of the housing market to begin.

Gross says one reason the Fed’s had trouble influencing the situation so far is that private investment firms that marketed the complex securities that financed mortgage lenders during the housing boom have created a “shadow banking system.”

“What we are witnessing is essentially the breakdown of our modern day banking system, a complex of levered lending so hard to understand that Fed Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August,” Gross wrote in his most recent monthly briefing to clients. Unchecked by regulators, Gross said, the shadow banking system has been “free to magically and mystically create and then package subprime mortgages into a host of three-letter conduits that only Wall Street wizards could explain.”

While some lenders say market forces have already put the brakes on the worst excesses of the housing boom, those still able to make loans the old fashioned way — such as banks that loan money against customer’s deposits — could soon be subjected to a slew of new regulations and laws.

After delinquencies and defaults began to rise in 2006, federal bank regulators introduced new guidelines for subprime and “exotic” loans such as interest-only and payment-option ARMs.

Under pressure from lawmakers, the Federal Reserve on Dec. 18 announced plans to make some of those guidelines mandatory, as part of proposed regulations that would extend provisions of the Home Ownership and Equity Protection Act (HOEPA) — which previously applied to only a small fraction of loans carrying extremely high interest rates — to all subprime and some alt-A loans.

Some consumer advocates and lawmakers say the Fed’s proposed regulations — including limits on yield spread premiums, prepayment penalties, and mandatory escrow accounts for taxes and insurance — don’t go far enough. Congress is debating even more drastic measures that some fear would worsen the credit crunch by creating new liability for investors in mortgage-backed securities (MBS), or by casting doubt on the ability of loan servicers to collect existing and future mortgage debts (see separate article).

Cost of borrowing going up

Private mortgage insurers PMI Group Inc. and MGIC Investment Corp. have raised or are raising rates for borrowers with lower credit scores and loan-to-value (LTVs) ratios above 95 percent. Both companies have discontinued mortgage insurance on loans with LTVs above 95 percent for borrowers with credit scores below 620.

Both companies have recently experienced heavy losses from claims, which are expected to rise in 2008. MGIC Investment Corp. on Oct. 17 reported a $372.5 million third-quarter loss, and the company said it would remain in the red in 2008 as it faced up to $1.5 billion in claims. PMI Group lost $86.8 million during the third quarter as paid claims, loss adjustments and reserves for losses grew to $372 million.

“What we found when looking at our portfolio was that the combination of a low FICO score and high LTV doesn’t have a high-enough likelihood of sustainability for us to be comfortable insuring it,” said Beth Haiken, a spokeswoman for PMI Group, which raised rates in October. “It doesn’t do anybody any good to be putting people into homes if they don’t have a pretty good chance of success.”

MGIC, which is implementing its underwriting changes Jan. 14, will no longer insure reduced-documentation loans for investment properties or cash-out refinances. Borrowers applying for insurance on alt-A loans must have at least 50 percent of their income from a self-employed source to qualify.

“What we’re doing is reflecting what’s happening in lending across the county,” said Mike Zimmerman, VP of investor relations for MGIC, noting that prices for home buyers with good credit aren’t going up. “One of our objectives as a company is to serve first-time home buyers. Low- and moderate-income home buyers are the constituency we serve. But we are also trying to create sustainable home ownership. If you put standards in place, by definition someone won’t qualify. The question is what’s sustainable.”

Some facing higher mortgage insurance premiums may be able to obtain a loan backed by the Federal Housing Administration (FHA) instead. Depending on their income, others may be able to claim a tax deduction on private mortgage insurance payments, as Congress has passed legislation that would extending the current exemption for three years, which President Bush is expected to sign.

But MGIC will no longer insure any loans with LTVs exceeding 95 percent in California and Florida — where many markets that saw prices skyrocket during the boom have now turned around.

Geography is playing a role for lenders, as well, and bargain hunters in markets where prices are falling can expect to be subjected to more scrutiny and tighter terms.

New flow business pricing announced in November by Fannie and Freddie create new surcharges on most loans purchased after March 1 for borrowers with credit scores below 680. The surcharges range from 0.75 percent for borrowers with FICO scores between 660 and 679 to 2 percent for borrowers with scores less than 620. Lenders are already passing the new loan-level price adjustments — which apply to loans with down payments of less than 30 percent — on to borrowers.

The government-sponsored enterprises (GSEs) are also collecting 0.25 percent surcharges on loans with subordinate financing when combined loan-to-value ratios (CLTVs) exceed 90 percent — regardless of the borrower’s credit score. Borrowers with credit scores below 720 will pay the extra 0.25 percent surcharge when CLTV exceeds 75 percent.

Interest-only loans with subordinate financing will carry surcharges when CLTVs exceed 75 percent. The additional fee is 0.25 percent for borrowers with FICO scores of 720 or above, and 0.5 percent for credit scores below 720.

A month after announcing the new surcharges, Fannie and Freddie said that beginning Jan. 15, they would reinstate a policy requiring lenders to reduce by 5 percent the maximum loan-to-value (LTV) ratio of a particular loan product when a property is determined to be in a “declining markets.”

The policy would apply whenever an appraisal determines a property is in a declining market, or when Desktop Underwriter, an automated loan underwriting program, flags a property as “being located in either an area of declining home prices or in an area where it may be difficult to assess home values.” If a lender still wants to offer maximum financing, they must be able to provide documentation supporting an assessment that the property is not located in a declining market.

Lenders and appraisers are also advised to consult the Standard & Poor’s Case-Shiller home-price index, the Office of Federal Housing Enterprise Oversight (OFHEO) Index, and statistics on changes in median home prices compiled by the National Association of Realtors.

Fifteen of the 20 major metropolitan areas tracked by the Standard & Poor’s Case-Shiller price index saw annual price declines, according to the latest release. Atlanta, Charlotte, Dallas, Portland and Seattle were the exceptions. All 20 metro areas saw price declines from August to September.

OFHEO’s latest price index, which excludes transactions involving mortgages above the $417,000 conforming loan limit, showed annual price declines in 83 of 287 metropolitan statistical areas, and quarterly declines in 140 MSAs.

While Fannie and Freddie’s decision to introduce new surcharges and reduce maximum LTVs in declining markets caused a stir, there was an even greater uproar over a new “adverse market delivery charge” of 0.25 percent on all loans purchased or securitized by the GSEs after March 1.

The National Association of Home Builders criticized the move, initially announced by Fannie, saying it appeared that its main motivation was to allow the company to maintain minimal capital requirements put in place by federal regulators after management and accounting scandals at both companies.

“This is like a mini perfect storm created by Congress’s inability to pass meaningful GSE reform and OFHEO’s regulatory inflexibility in a time of crisis,” NAHB said in a press release. “So it should be of little surprise to anyone that, under these circumstances, a GSE would resort to a mortgage surcharge to meet capital requirements.”

In announcing the new adverse market charge on Dec. 5, Fannie Mae officials said it would “ensure that we remain a fully available secondary market partner to our lenders by providing long-term commitments they can rely upon to provide borrows with steady and reliable access to mortgage financing.”

Troubles at Fannie and Freddie

While Fannie and Freddie have made significant progress in putting behind them management and accounting scandals that forced them to restate several years of earnings, the housing downturn has started showing up in their bottom lines — throwing into doubt their ability to play a greater role in extricating financial markets from the credit crunch.

Under 2004 agreements with federal regulators, Fannie and Freddie must maintain 30 percent more capital than previously required, until regulators are satisfied that improved management and accounting procedures are in place. The GSEs also have caps limiting the total dollar value of loans they can hold in their portfolio to about $1.5 trillion.

By the end of September, regulators said Freddie Mac had put in place all of the management and accounting practices stipulated in a 2003 consent order, and Fannie Mae was in compliance with 88 percent of its order.

But as it returned to regular financial reporting in November, Fannie reported $1.4 billion in third-quarter losses. Although the losses were not related to accounting or management practices, they threatened future growth. The $41.7 billion in core capital on hand at Fannie exceeded the tougher new minimums by only $2.3 billion.

Freddie Mac had $2 billion in third-quarter losses, and with just $600 million in surplus capital was forced to sell $45 billion in loans in September and October, the company said. To raise additional capital, between them the GSEs were forced to issue $13 billion in preferred stock and cut dividends to shareholders.

In early 2007, Fannie Mae Chief Executive Officer Daniel Mudd was outspoken in advocating a greater role for his company during the housing downturn, calling for a 10 percent increase in the cap on Fannie’s loan portfolio. Freddie Mac CEO Richard Syron has also pushed for more leeway.

Some housing industry groups want the $417,000 conforming loan limit raised to allow the GSEs to buy jumbo loans.

Proponents say Congress could help stimulate borrowing by raising the conforming loan limit, giving Fannie and Freddie more room to guarantee and securitize “jumbo” loans. Lawmakers could also bump up the $1.5 trillion cap on the GSEs’ combined loan portfolios — but probably not without the acquiescence of the Bush administration.

While some Democrats agree that the portfolio caps should be lifted — if only temporarily — and the $417,000 conforming loan limit raised, the Bush administration has said Congress must first pass legislation strengthening oversight of the GSEs. The House and Senate have been unable to agree on the fine points of so-called GSE reform legislation.

Between them, Fannie and Freddie have committed to purchase more than $40 billion in refinance loans for current subprime borrowers — a goal regulators say they should be able to accomplish within the current restrictions.

But if the GSEs are to play an even greater role in 2008, Mudd and Syron will have to find ways to raise additional capital, and convince lawmakers that Fannie and Freddie deserve their trust.

Trouble ahead?

In the meantime, the Mortgage Bankers Association estimates that 1.5 million homes will enter the foreclosure process in 2007, as third-quarter foreclosure starts hit 0.78 percent, an all-time high since the MBA began surveying lenders in 1972.

MBA Chief Economist Doug Duncan said he expects housing markets to bottom out no later than the third quarter of 2008, but that “substantial inventories” will result in full-year price declines for 2007 and 2008.

Testifying before the House Financial Services Committee in December, FDIC Chairman Sheila Bair said about 1.7 million hybrid ARM loans with an outstanding balance of $367 billion are scheduled to undergo their first payment resets in 2008 and 2009. Only about 2.9 percent look like easy candidates for refinancing, with loan-to-value ratios below 80 percent at origination and debt-to-income ratios below 30 percent.

In 2008 alone, Bair said, 1.3 million hybrid ARM loans scheduled to reset, and more than 200,000 are already 90 days or more past due or in some stage of foreclosure even though their payments have not yet adjusted.

The Bush administration is pushing for Congress to pass legislation that would allow the Department of Housing and Urban Development to expand FHA loan guarantee programs, which are a centerpiece of the administration’s foreclosure prevention efforts.

HUD Secretary Alphonso Jackson says that pending FHA modernization legislation — along with the new FHASecure loan guarantee program that allows borrowers who are already in default to refinance into fixed-rate loans — could allow FHA to guarantee up to 800,000 loans in fiscal 2008.

The Bush administration also hopes loan servicers who have joined its “HOPE NOW” coalition will refinance or modify up to 1.2 million subprime ARM loans, although critics say only a fraction of that number will be helped.

Wells Fargo expects to find “workable solutions” for up to 88 percent of subprime ARM loans that are expected to reset by the end of 2008, with borrowers either paying off their loans in full, refinancing, coping with higher loan payments, or benefiting from a workout, said Brad Blackwell, executive vice president of Wells Fargo Home Mortgage, at a congressional hearing in November.

Countrywide Financial Corp. has said it hopes to refinance or modify $16 billion in mortgage loans held by about 82,000 borrowers. Countrywide estimates that $10 billion in subprime loans will qualify for refinancing into prime or FHA loans, and that it will modify the terms of another $4 billion in prime and subprime ARM loans in which borrowers are current on their payments. The bank also plans to modify the terms of $2.2 billion in subprime loans in which borrowers are delinquent as a result of a reset.

According to Scott Polakoff, COO of the Office of Thrift Supervision, 41 percent of subprime borrowers who experience rate resets become delinquent. Some 30 percent become delinquent before a rate reset. More than 27 percent of hybrid ARM loans made in conjunction with home purchases in which the borrower put no money down became delinquent.

“A loan modification that extends the starter rate will not help borrowers who ultimately will be unable to pay under their current starter rate,” Polakoff said. Effective loan modification programs generally focus on borrowers who “make it to their rate reset relatively free of serious past payment problems.”

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