Editor’s note: How bad will the real estate market get before it gets better? Inman News compiles the facts and analysis in this five-part series. (Read Part 1, “The housing market: How bad will it get?” Part 2, “Vendors cope with real estate downturn“; Part 3, “Market forces, regulators threaten credit crunch“; and Part 4, “Investor worries rise.”)
As market forces make it more expensive or impossible for some borrowers with poor credit to obtain a mortgage or refinance an existing exorbitant loan, some policymakers are wondering how government-supported loan guarantee and insurance programs fell out of favor with borrowers, and how to go about restoring them.
Bundling up mortgage loans by the thousand as collateral for investments known as mortgage-backed securities (MBS) is a practice dating back to the 1970s.
The practice took off with the introduction of collateralized mortgage obligations, or CMOs, which combine classes or “tranches” of MBS with varying degrees of risk and returns. Collateralized debt obligations (CDOs) can be backed by other assets besides mortgages. CMOs and CDOs employ derivative investments such as interest rate and credit swaps, Treasury futures, and options to help managers of bond funds manage risks like changes in interest rates and borrower prepayment.
Government-sponsored mortgage repurchasers Fannie Mae and Freddie Mac once dominated the mortgage securitization market. But in 2005, “private label” lenders — banks, Wall Street investment firms, insurance companies and home builders — overtook Fannie and Freddie in MBS issuance. Private-label lenders issued $1.2 trillion in mortgage-backed securities, compared with $908 billion for Fannie and Freddie, the lowest level in five years.
At the end of 2006, Fannie and Freddie held or guaranteed 39.3 percent of the $11 trillion in total U.S. residential mortgage debt, down slightly from 39.9 percent at the end of 2005.
One reason the government-sponsored entities, or GSEs, have been losing market share to private lenders is the rising popularity of nontraditional mortgages that don’t meet Fannie and Freddie’s underwriting standards.
Another is that purchases of many homes in fast-appreciating markets require mortgages that exceed the conforming loan limit, making them ineligible for repurchase by the GSEs. At $417,000, the conforming loan limit is below the median home price in many high-cost areas.
That’s also an issue for borrowers seeking low-cost loans insured by the Federal Housing Administration (FHA) or guaranteed by the Department of Veterans Affairs (VA). In high-cost areas, the FHA can only insure loans up to 87 percent of the conforming loan limit, which excludes single-family home loans greater than $362,790. That’s one reason only 2.7 percent of single-family mortgages originated in 2006 were FHA-insured or VA-guaranteed, according to a report by the Office of Federal Housing Enterprise Oversight.
Many in Congress support raising the conforming loan limit in high-cost areas in order to let Fannie and Freddie purchase more loans.
The GSEs have both pledged to develop new loan products that will serve as alternatives to subprime loans. Freddie Mac announced this spring it would purchase $20 billion in fixed-rate and hybrid adjustable-rate mortgages intended for borrowers with less-than-perfect credit.
But the GSEs made it harder for lawmakers who favor an expanded role for the companies to win support for such ideas when they embroiled the companies in accounting and management scandals. During the housing boom, regulators determined that the GSEs didn’t follow proper accounting procedures for some of their investments, which forced them to restate billions in earnings.
Under the terms of a May 2006 consent order, Fannie must limit its net mortgage portfolio assets to year-end 2005 levels, or $727.7 billion. Freddie Mac has voluntarily limited growth in its mortgage loan portfolio to one-half percent per quarter from a mid-2006 baseline of $710.3 billion until it resumes regular financial reporting.
Legislation that would overhaul the oversight of Fannie and Freddie was stalled in the Senate in 2006 over the issue of portfolio caps. A bill passed by the House in May sought to resolve the issue by giving federal regulators some authority to set limits on the GSE’s portfolios, without establishing specific caps.
In the mean time, Fannie and Freddie have had fewer restrictions on their loan guarantee business. By the end of 2006, the GSEs guaranteed a total of $2.9 trillion in mortgage-backed securities held by other investors, a 13 percent increase from the year before.
Congress is also weighing an FHA modernization bill, which would raise the eligible loan limit in high-cost areas and allow FHA to use risk-based pricing and back zero-down loans to serve subprime borrowers.
In a recent report, the Government Accountability Office estimated that the FHA could have insured 9 to 10 percent more loans in 2005 with the proposed higher limits in place.
Risk-based pricing entails decreasing premiums for lower-risk borrowers and increasing them for those with higher risk. The GAO estimates that about 43 percent of FHA borrowers would have paid the same or less than they actually paid in 2005, that 37 percent would have paid more, and 20 percent would not have qualified for FHA insurance at all.
The FHA estimates that if it’s able to insure more loans using risk-based pricing, it could generate $342 million in revenue that could be used for other housing programs, compared with a $143 million taxpayer subsidy if current loan insurance procedures are continued.
But the GAO report questioned the wisdom of lowering the FHA’s down-payment requirements, saying the proposal is “of particular concern given the higher default rates on these loans and the difficulty of setting prices for new products whose risks may not be well-known.”
While FHA has improved its ability to forecast loan performance by incorporating more variables into its models, the GAO report said, authorizing FHA to offer a zero-down product “at a time when stagnating or declining home prices in some parts of the country could increase the risk of default.” The GAO said a “prudent way” to launch such a product would be through a pilot program.
Those are concerns shared by Joseph R. Mason, associate professor of finance at Drexel University’s LeBow School of Business.
“If the government wants to get into that business, I want one of those loans, because I could get a lot nicer house,” he joked.
In a recent paper, “How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions?” Mason and co-author Joshua Rosner point out that the Department of Housing and Urban Development requires servicers of FHA-guaranteed loans to use loss-mitigation strategies with troubled borrowers. Mason and Rosner say that strategy may have long-term risks, citing studies that put the rate of re-default on FHA loans with modified terms as high as 25 percent.
“It doesn’t make sense to provide economically infeasible products, in the sense that the loan terms need to be modified if the borrower is to repay them, or you are going to forgive principal or lower interest rates,” Mason told Inman News.
In another recently published report, the GAO said that the FHA lost market share not only because of restrictive loan limits, but because historically low interest rates and rising home prices increased the demand for conventional loans with more flexible payment and interest rate options. In the end, those loans may have proved more costly to borrowers, the GAO noted, but borrowers were lured by initial lower payments.
From 1996 through 2005, the GAO said, FHA’s market share fell from 19 percent to 6 percent, while subprime lenders boosted their market share from 2 percent to 15 percent. Among minorities, FHA’s market share fell even more drastically, from 32 percent to 7 percent. By 2005, subprime lenders had captured a 24 percent share of home loans to minorities, compared with 6 percent in 1996.
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