Editor’s note: This is Part 6 of a seven-part series.
The Obama administration does not know what to do with Fannie Mae and Freddie Mac. While the mixed private/public model under which they had operated has been thoroughly discredited, and the agencies are now in a government conservatorship, they are critically important in today’s market.
Because there is a fear of rocking the boat, the issue of what to do with them going forward has been placed on hold. Such delay is a good thing if the time is used to get it right.
In the long run, one of the agencies should be entrusted with developing a private secondary market to replace the one that collapsed during the crisis. In the short run, both agencies need to get on board with the government’s policy of stimulating economic recovery.
Developing a new private secondary market: As discussed last week, the new market should have the following major features:
- Firms issuing mortgage securities retain full liability for every security they issue. This makes the market safe for investors.
- New loans are financed by selling them directly into open security issues of the same type. This makes the market efficient.
- Borrowers have direct access to the secondary market, borrowing at the price of the security sold to finance their loan, plus a rate markup and fees charged by the lender. This makes the market transparent, protecting borrowers against being overcharged.
- Borrowers have the right to pay off their mortgage by buying back an equivalent amount of bonds, at the lower of par and the market price. This makes the market stable, protecting borrowers against rising market interest rates.
Fannie Mae and Freddie Mac should compete to determine which will be selected to develop this new market. If there ever was a need for two agencies in the past, there clearly will be no such need in the future. The agency selected to oversee the development of the private market would recast its own secondary market operations so that the markets work in the same way.
The other agency should be placed in liquidation. (An updated version of this article at www.mtgprofessor.com will indicate some of the criteria the government might use in selecting the surviving agency.)
Participating in economic recovery: Although they are now part of the federal government, the agencies are operating at cross purposes to the Federal Reserve, as if they are trying to earn their way out of conservatorship.
While the Federal Reserve has purchased huge amounts of their mortgage-backed securities to lower interest rates for homebuyers and refinancers, the agencies have been adding a series of price add-ons that have raised financing costs to countless millions of potential borrowers. …CONTINUED
The price increments imposed by the agencies are called "Loan Level Pricing Adjustments" (LLPAs) in Fannie jargon and "Post-Settlement Delivery Fees" (PSDFs) in Freddie jargon. They are upfront payments expressed as a percent of the loan balance and are based on loan-to-value ratio (LTV), FICO credit score, and various loan characteristics related to risk.
Before the crisis, they were largely limited to special programs, but in March 2008 they were applied to standard programs. In March of this year, they were increased by both agencies.
For example, the LLPA today on a loan to a borrower with a credit score below 620 is 1.5 percent if the LTV is between 60.01 percent and 70 percent, and 3 percent if the LTV is above 70 percent.
If the loan is on a property with two to four dwelling units, there is an additional LLPA of 1 percent. If the property is a rental, another LLPA kicks in for 1.75 percent if the LTV is 75 percent or lower; 3 percent if the LTV is between 75.01 percent and 80 percent; and 3.75 percent on LTVs above 80 percent.
LLPAs and PSDFs are cumulative. If buying or refinancing a two-unit investment property, Fannie Mae will charge a borrower with a FICO below 620 and an LTV between 80.1 percent and 85 percent 3 percent (high LTV, low FICO), plus 1 percent (two-unit property), plus 3.75 percent (high LTV on an investment property) … for a total of 7.75 percent. More likely, such a borrower would give it up, as millions have.
I am a strong believer in risk-based pricing, but the agencies are overshooting the mark in order to generate revenue, as if this will offset their excessive liberalizations during the years of boom and euphoria.
If a borrower applying to refinance has been current on his loan for at least the last 12 months, there is no good reason to charge any price premium at all, regardless of LTV, credit score, type of property or loan purpose.
Underwriting requirements have also been tightened, with many if not most self-employed borrowers now shut out of the market. With full documentation now mandatory, I see a steady stream of self-employed refinance applicants with perfect payment records, high credit scores and substantial equity who can’t qualify.
Before 2008, such applicants would qualify under stated-income documentation, which was originally designed for them. The stated-income option was abused during the housing bubble, and the agencies’ response was to eliminate it rather than fix it. Shameful.
Appraisal rules have also become a major bottleneck. On May 1, 2009, the agencies issued a Home Valuation Code of Conduct (HVCC), which is discussed in detail on my site.
The upshot is that HVCC has reinforced the downward bias in appraisals that developed after the crisis, increased the time it takes to get an appraisal, eliminated the ability of a borrower to use the same appraisal with multiple loan providers, and made it nearly impossible to get any appraisal at all when the appraiser can’t find three comparables in the same area.
Before HVCC, I never ran into cases where prospective borrowers were unable to get any appraisal, but now I see it often. The agencies should be required to find ways to undo the damage that HVCC has inflicted on this market.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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