Posted Thu Jul 10, 12:14 pm ET
Posted By: Dirk van Dijk, CFA
With Fannie and Freddie falling off a cliff in recent days, I thought it might be worthwhile to repeat this excerpt from my Strategy Report of February 2008. I'm not sure that all of the problems at the GSE's stem from the raising of the Jumbo limit, but it sure didn't help the situation.
"Putting Fannie in Peril
The stimulus package does contain one very dangerous and unwise provision. It will raise the cap on mortgages covered by the FHA and the GSE's -- Fannie Mae (FNM) and Freddie Mac (FRE) -- to $730,000 from the current limit of $417,000 and does so retroactively to July of last year. Fannie and Freddie both have serious recent problems with their accounting, and are capital constrained.
As it stands now Fannie has less than $40 billion in equity supporting $840 billion in on balance sheet assets, and that doesn't count the even larger amount of assets it guarantees.
The story is the same for Freddie. They probably already have billions of toxic mortgages either on their books or under their guarantee (we should know a bit more about how much when they report their fourth quarter results). Given this, every $700,000 mortgage that it brings on its balance sheet is four $175,000 loans it can't bring onto its balance sheet.
We have Fannie and Freddie in the first place to help support mortgage liquidity for low and moderate income homeowners. Well, with a 20% down payment, a $730,000 mortgage means a house worth over $900,000. Regardless of location, those are not exactly slum dwellings. The principal and interest payments alone (not counting property taxes, insurance or even things like heating the home) exceed the median family income in this country.
Jumbo loans also create significant problems if packaged into securities that the GSE's guarantee. Jumbo loans have been particularly hard hit in the current credit crunch, as GSE backed loans have been just about the only ones being funded. A year ago the spread between a conforming 30-year fixed mortgage and a 30-year fixed jumbo was 24 basis points. Today it stands at 103 basis points, and that is after Congress has given its OK to raising the caps.
These changes will inevitably raise the cost of the current moderately sized mortgages. For starters, they will substantially increase the geographical concentration of the securities, since California represents 50% of all Jumbo loans. They also have very different prepayment characteristics than the current conforming loans. Given the number of the jumbo loans that are upside down (recall that half are in California, the state which has been one of the hardest hit in terms of housing price declines so far) if the GSE's stick to their current underwriting standards, then they will not take on many of them.
In that case, the move will not make that much difference. That would include calculating the loan-to-value ratios based on current market values of the house, not the values when the loan was first taken out. From the fact that the change in standards is retroactive, it is clear that there will be substantial political pressure to relax their standards. It was noteworthy that there was no increase in regulatory oversight for the GSE's included in the package.
I should also note that I am not alone in these worries. The chief regulator of the GSE's, James Lockheart recently said:
'The GSEs have become the dominant funding mechanism for the entire mortgage system in these troubling times. They are fulfilling their missions of providing liquidity, stability, and affordability to the mortgage markets. In doing so, they have been reducing risks in the market, but concentrating mortgage risks on themselves. . . .
'The risks are beginning to take their toll. Public disclosures indicate that Freddie Mac will report annual losses for the first time in its history and Fannie Mae for the first time in 22 years. Their missions, as well as Congressional and many other pressures, are demanding that they do more and take on more risks in areas new to them - subprime and jumbo mortgages.
'As the safety and soundness regulator of Fannie Mae and Freddie Mac, I have to tell you that expansion of their activities would be imprudent unless the regulator has significantly more powers and more flexibility to use those powers. Given the tremendous stresses on the mortgage markets, the American people cannot afford to have Fannie Mae, Freddie Mac, or the 12 FHLBanks incapable of serving their mission...
'Now, I will turn to the temporary increase in the Conforming Loan Limit (CLL) as proposed in the Economic Stimulus package. OFHEO believes any increase in the CLL should be coupled with quick enactment of comprehensive GSE reform. The CLL provision in the stimulus package would increase the Enterprises risks by allowing them to enter the "jumbo" loan market. It would increase the maximum size loan those GSEs could purchase or guarantee from $417,000, to the lower of 125 percent of median area prices or $730,000, for mortgages originated between July 1, 2007 and December 31, 2008. This change should help lower interest rates on some jumbo mortgages, but other potential implications deserve attention.
'Jumbo loans would present new risks to the already challenged GSEs. The prepayment and credit risks are different than those of conforming loans. The provision also pushes the GSEs to increase their geographic concentration in some of the riskiest real estate markets. Roughly half of all jumbos are in California. Underwriting them successfully will require new models and systems to ensure safe and sound implementation. Capital also would present challenges even if all newly conforming mortgages are securitized. A $600,000 loan requires as much capital as three $200,000 loans.'[1]
While the change is supposed to be temporary, if you believe that to be the case, you clearly don't understand how Washington works. When it expires, it will be spun as a radical decrease in the conforming loan limits, depriving the blessings of homeownership to millions. It will be Bush's temporary tax cuts all over again.
In essence, this move is a subsidy to the wealthiest homeowners in the country, and to the lenders who imprudently lent to them. It will shift the toxic junk off the balance sheets of the banks onto the GSE's, substantially raising the prospect that the GSE's will need to be bailed out by the government. If they go down, the cost of such a bailout could easily top $1 Trillion. Politically it would be much easier to bail out the GSE's than Citigroup (C) or Washington Mutual (WM)."
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