Point of View: The Price of Risk Creep

Excerpts of Mr. Lockhart's remarks about the housing downturn's impact on Fannie Mae and Freddie Mac at the 44th annual conference on bank structure and competition in Chicago are presented as our viewpoint.

As nontraditional lending boomed, the enterprises purchased more alt-A and interest-only mortgages and accepted more loans with higher LTV ratios and lower borrower credit scores, but their pricing of those transactions often did not fully compensate for heightened credit risk. A growing share of borrowers whose first mortgages the enterprises purchased also took out second, "piggyback" loans, yet the enterprises did not have complete information on those seconds and could not fully reflect the actual total LTV ratios in their guaranty fee pricing. Further, despite the growing risk of a house price correction, the pricing models of Fannie Mae and Freddie Mac assumed that house prices would continue to grow at their long-term trend. In sum, market developments and the enterprises' responses increased their mortgage credit risk to a degree that was not fully offset by higher capital or fee income.

Second, subprime, alt-A, and other nontraditional mortgages and the private-label MBS they backed were relatively new and untested financial products whose performance in a period of rising interest rates and low or negative house price appreciation was quite uncertain. Grade inflation in credit ratings of structured securities has been evident for some time, and we have seen numerous previously highly rated private-label MBS downgraded over the past year. Thus, those securities posed credit risk as well as the risk of fair value losses due to falling market prices. Those risks were not fully reflected in the enterprises' initial pricing. At midyear 2007, before the start of the current market turmoil, Fannie Mae and Freddie Mac together held $257 billion in private-label MBS backed by subprime, alt-A and home-equity mortgages. By the end of the first quarter of this year, that total had declined to $206 billion.

Third, the growing risk of a house price correction and the risks posed by subprime and nontraditional mortgages also affected the servicers, mortgage insurers, bond insurers, and even the derivatives providers that are major counterparties of Fannie Mae and Freddie Mac. Thus, the enterprises' counterparty credit risk increased as well.

Fourth, the models Fannie Mae and Freddie Mac use to manage risks were increasingly inadequate. Mortgage product and other financial innovation, globalization, and changes in investor and borrower behavior were increasing the likelihood of market outcomes that the enterprises' models did not anticipate. Further, the models are designed to project ultimate credit losses, not potential near-term fair value losses, stemming from shifts in demand and market illiquidity, which are increasingly reflected on balance sheets and in earnings statements.

Those increased risks became evident after the mortgage market turmoil began last August. Fannie Mae and Freddie Mac reported large losses in the third and fourth quarters of 2007 and the first quarter of this year. Specifically, Fannie Mae reported $7.1 billion in losses in those three quarters, while Freddie Mac reported losses of $3.8 billion on top of losses in three of the previous four quarters. In response, and with vigorous encouragement from OFHEO, each enterprise has raised substantial amounts of capital starting in November of last year. Those capital infusions, which could total over $25 billion after Freddie Mac completes its common and preferred stock issues, have allowed the enterprises to maintain capital cushions above regulatory capital requirements and to be a source of strength for mortgage lending and the housing sector. By guaranteeing MBS backed by conventional mortgages with balances up to the conforming loan limit, they have ensured that the largest segment of the primary mortgage market has continued to function smoothly. They have also provided liquidity to the secondary market by purchasing MBS for their retained mortgage portfolios.

In the second half of 2007 and the first quarter of this year, Fannie Mae and Freddie Mac guaranteed $831 billion in MBS and purchased $178 billion in whole loans and MBS for their retained portfolios. During the first quarter, the enterprises' activity represented 68% of all single-family mortgages originated, up from nearly 35% in the second quarter of 2006. (c) 2008 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com/ http://www.sourcemedia.com/

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