On Friday, July 13th (of all days), Fannie Mae and Freddie Mac dropped a bomb on weak home and mortgage markets. The new damage will take time to quantify, but may be considerable. The tale behind the act is clear, and just shy of unbelievable.
On Friday, Sept. 29, 2006, the Federal Reserve (joined by all other banking regulators) issued a “guidance” on nontraditional mortgage risks. It demanded that any mortgage containing an interest-only feature be underwritten at the highest possible interest rate or subsequent amortizing payment, and that any mortgage containing a negative-amortizing feature be underwritten at the highest possible balance and interest-rate adjustment.
No consideration for size of down payment or strength of borrower or for length of fixed-rate interval, one-month adjustable-rate mortgages (ARMs) treated the same as 10-year. No thought given to the “option ARM,” offered by the trillion since 1980, the oldest ARM in the industry, and not a shred of evidence since roll-out that its option structure had caused outsize foreclosures in any market. I don’t like option ARMs and don’t sell them (neg-am is too great a temptation to self-deception), and salespeople have abused them, among other things claiming that neg-am helps to prepay loans. It is surprising that the sales propaganda has not done more harm, but it has not.
I read the Sept. 29 guidance that night, and went to work the following Monday afraid, asking our underwriters to evaluate the credit contraction from e-mail bulletins certain to arrive.
The e-mails never came. The industry, increasingly nonbank, Wall Street-based, ignored the guidance. Three months later, OFHEO, the regulator of Fannie and Freddie, sent those two agencies a heated blast demanding a response. Nothing followed. I hoped that the Fed and others had second thoughts, realizing the intellectually lazy foundation for the guidance and its meat-cleaver approach, right out of the rulebook for 1932 bank examiners, requiring rapid foreclosure and seizure and closure of banks.
This winter and spring I called and called, trying to figure out the future of the guidance … the Fed, OFHEO (no stuffier press offices on the planet; the Kremlin is happier to hear from you), Fannie, mortgage insurers, and got nothing. I do not know what internal politics forced the thing forward, but here it is. Fannie’s “Desktop Underwriter” will be recalibrated on July 22 to enforce the guidance.
Two forms of hell will break loose, and one good outcome. The good: the industry will shortly have fewer salespeople, with luck losing the ones who should not have been given a telephone in the first place. Then, quickly, troubled borrowers trying to refi off their subprimes or other re-setting ARMs into interest-only loans to minimize payments will be out of luck. Add to that the rising foreclosure count. Also out of luck, the millions who planned defined ownership periods, safely using 7- or 10-year interest-only loans. Then the families with solid but unpredictable incomes (sales or seasonal, for example), for whom an option ARM was a godsend … the Fed and its pinched pals just made your lives riskier. It will take a little while longer to assess the harm to housing markets already desperate for demand.
Hell number two may or may not develop, but it will be a special place for the regulators themselves. The Fed and OFHEO have forced this bad idea on Fannie and Freddie, but what of Lehman, the giant Wall Street broker-dealer, proprietor of Aurora Loan Services, the dominant Alt-A mortgage wholesaler/securitizer, and others like it? (Note: the bulk of Alt-A are perfectly good credits, although the class does include junk tiers and trash ones indistinguishable from subprime). Lehman/ALS is not regulated by OFHEO, or much of anybody else except the SEC and NASD. A lot of the non-Fannie/Freddie world uses F&F software engines for loan approval; but, what’s to stop the Lehmans from offering back-alley interest-only and neg-am loans? The Fed has done backflips to avoid pointing the predatory-mortgage, suicidal underwriting finger at The Street, where it belongs.
Back to the damage. Subprime lending is contracting fast, both by market and regulatory force, and should. “Back-look” review suggests that perhaps a majority of these borrowers could have been approved for better loans (FHA, outside-edge Fannie-Freddie, especially if mobilizing family help, or doing something crazy like saving a little money), and so the net contraction of subprime purchasing power in troubled housing markets may not be terribly large. This new set of criteria is going to diminish purchasing power among the worst-possible group, the “A”-quality borrower. Some of the diminution will be subtle: if approval for an interest-only or option loan is not available, and a price range therefore out of reach, many buyers will step out altogether.
The most elementary regulatory concept at the end of a credit cycle: Do not make it worse by ex post facto regulation. Do not close the door on a burning barn with horses still inside. Be inventive, careful, delicate and incremental. Develop regulation working backward from actual damage, not Depression-era banking notions of “safety and soundness.”
The real housing-market trouble today has been caused by Wall Street’s ability to distribute risk beyond Main Street’s ability to tolerate temptation and foreclosures. Everyone out here in the real world knows that the foreclosure poster child is the low-down-payment borrower whose income was not properly underwritten. Instead of this miserable affair, you might have banned “no-doc” underwriting of any loan with less than 20 percent down. You might have banned stated-income underwriting for any loan with less than 10 percent down, and for any interest-only or neg-am structure. You might have limited rate adjustments for any loan with a fixed-rate interval shorter than five years, and likewise confined them to lower loan-to-value ratios. Then stopped for a few months to see what happened.
Nope. Meat Axe scores one, Judgment nothing.
Lou Barnes is a mortgage broker and nationally syndicated columnist based in Boulder, Colo. He can be reached at firstname.lastname@example.org.