Jumbo Mortgage Risk Will Topple the Teetering GSEs

When President Bush signed the Economic Stimulus Act into law making jumbo mortgages GSE insurable, he may have unwittingly pushed our GSEs, Fannie Mae (FNM) and Freddie Mac (FRE), already on tilt, over the edge. If you think we have a housing crisis now, wait until you see what the demise of the GSEs and subsequent secondary mortgage market would do.

Let’s start with a few facts here to bring you up to speed on all the players and the game.

First, we have the GSEs: Fannie Mae and Freddie Mac, who for all practical purposes create and dominate our “prime” credit, full documentation, conforming loan limit (up to $417,000), bread and butter, mortgage products. They are considered “quasi-government” organizations but are really just NYSE traded companies with much more responsibility since they insure mortgage loans so they can be “pooled” and sold to Wall Street.

With Wall Street ready and eager to buy anything “insured” by the government, we all now enjoy a virtually limitless source of mortgage money. When mortgage money is readily available, the housing market is helped…and conversely, a lack of mortgage money hurts the housing market. Of course this was the sole reason in the beginning for the GSEs; to support the housing market by maintaining a sound but liquid secondary mortgage market.

Second, the Office of Federal Housing Enterprise Oversight [OFHEO], the closest thing Fannie Mae and Freddie Mac have to a regulator. OFHEO became more important as both GSEs had a few “accounting scandals” ala Enron a few years back. Moving forward, they have more often than not been the “voice of reason” when it comes to keeping the GSEs in check.

Since private mortgage insurers like PMI, MGIC, and Radian, are recently coming under suspicion for being on the brink of collapse, it’s only prudent to ask are the “public” versions of mortgage insurers - the GSEs - feeling the same pinch. The recent scandals and the subprime meltdown as they affect GSE solvency are all concerns for the OFHEO.

Third, we have Congress. Specifically, ranking members in both House and Senate Banking Committees who are also supposed to be concerned with maintaining a viable secondary mortgage market, but really respond more to the huge campaign contributions that Fannie Mae and Freddie Mac are known for throwing around to get their way.

So now the stage is set with the players, let’s see how they interact.

The GSEs are stockholder owned private companies who are just as worried about next quarter’s stock price as any publicly traded company. Even thought they are entrusted with our nation’s mortgage market solvency, they may have another more pressing agenda. They pass out campaign contributions to both sides of the isle like so much candy to get favorable legislation passed and to keep regulations from holding back their “growth”.

Fannie Mae stock over the last 30 years has returned for its investors a 20,000% return…simply staggering!

Their regulator, the OFHEO, is funded by Congress, so by proxy assuming quid pro quo, FNMA controls its own regulators purse strings…not good.

Enter the Bush Administration Stimulus Package…

Inside the newly passed Economic Stimulus Act of 2008 contained a provision to increase the loan limit the GSEs could insure from $417,000 up to $729,750, making a formerly jumbo mortgage temporarily a conforming loan. This can apply to all jumbo loans made from July 31, 2007 to December 31, 2008.

Before the Bush Stimulus Package, the administration was adamant about not allowing an increase in conforming loan limits until Congress tackled full fledged GSE reform. They caved in to this OFHEO recommended safeguard to speed up the process of getting checks in the hands of eager consumers. A decision we may all some day regret.

In OFHEO Director, Mr. Lockhart’s words before the Senate Banking, Housing and Urban Affairs Committee on February 7, 2008, just days before the Stimulus Act was made law:

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.

I contacted the OFHEO and got a media representative on the phone in the hopes they would comment on what the Director meant by “new models and systems to ensure safe and sound implementation”.

I got a perfunctory, “We’ll call you back”… as of post time no call back was received.

So here we go again. The GSEs want some legislation that will help their bottom line but possibly put the solvency of our secondary market in danger…and they get it…over the voiced opposition of their own regulator.

In the same hearing, Mr. Lockhart reported some outlandish and worrisome facts:

Measured this way, each Enterprise’s leverage increased dramatically in the first nine months of 2007, exceeding 80 times their fair value of equity as of September 30th. Or if you look at it the other way around, there is only 1.2 percent of equity backing their mortgage exposure.

For the first three quarters of 2007, they have each lost $8 to $9 billion in fair value of equity. Their combined fair value equity at the end of the third quarter was $58 billion compared to $5.1 trillion in mortgage exposure.

This is astonishing. Talk about a company on tilt. The GSEs combined have a little over a penny for every $1 of exposure!

And yet every MBS they issue would still be given a AAA rating…including these new “jumbo mortgage” masquerading as conforming securities.

Lockhart summarizes nicely,

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.

Only Time Will Tell

I did reach John Hildreth, a lobbyist for the Credit Union Nation Association after reading a cogent article of his on GSE reform. I asked him about his take on whether increasing conforming loan limits given the increased risk “jumbo” loans posses was a “smart” move by the Bush Administration.

His reply was, “I’m not an economist. I’m a lobbyist. But my guess is only time will tell”.

Unlike Mr. Hildreth, I’m more prone to jump to a negative conclusion when it comes to the unmitigated greed of Fannie Mae and to a lesser degree Freddie Mac. I suspect there will be negative ramifications allowing a company whose losing money faster than it can count take on more risk, bigger risk, without the proper safeguards. After all, it does sound eerily close the recent subprime debacle or the more distant savings and loan debacle.

But maybe the built-in temporary status of these changes allowing jumbo loans into the mix will be a saving grace.

I’ll be holding my breath until December 31, 2008. It can’t come fast enough for me.

Disclosure: none

Comments

[Guy1:]

A well thought out reasoned post, but I must disagree that the GSE's will topple. In the current pseudo-socialist political environment we live in do you really think there will not be a massive WPA-like tax payer rescue of the mortgage system? We're on the verge of socialist universal health care and the rescue of greedy home borrowers - these same people won't let the housing market fall out of there never ending grasp for the daily control of our lives.

2008 Feb 29 09:02 AM

[Left Coast ...:]

This article had zero analysis of the risk profile of jumbo loans. The statistics I see show that jumbo loans carry a lower rate of default and lower rate of foreclosure than conventional loans -- resulting largely, it is thought, because these borrowers typically have higher incomes and career stability. Without an analysis like this, conjecture as to the risk to GSE's is just fear-mongering.

2008 Feb 29 12:14 PM

[mj99911:]

Mr. Blake seems know almost nothing about the secondary mortgage market and Fannie and Freddie. First, the $417,000 ceiling is not a line in the sand that cannot be crossed, but, in fact, is a limit that is determined annually by a compilation of national mortgage data. This limit has been increasing steadily for at least the last 30 years. The people who benefit most from conforming limits are home owners who live in low cost housing markets like Kansas, and those who benefits least live in California. The finance companies love the fact that they can charge an extra 75 to 150 basis points of interest for non conforming loans. These same finance companies have been trying for years to get rid of Fannie and Freddie so that they can charge higher interest rates on smaller loans as well.
Finally, to say that raising the conforming loan amount is a great risk is simply not true. The people who will benefit most from this will be people who live in high cost housing markets because they will be able to obtain mortgages with lower interest rates, which will reduce the overall profit of mortgage finance companies. Mr. Blake gives some fuzzy logic which can be refuted by the following simple example: If you bought a home 20 years ago in a low cost housing market, chances are that the house today is worth close to what you paid for it. If you bought a house in a high cost housing market, such as Southern California, the house value has probably gone up substantially. Which was the safer risk; a house that never appreciates with a conforming loan, or one with strong equity growth, and a non conforming loan. My parents bought a home in California in 1961, for $11,000. This same unimproved house sold in 2005 for $470,000.

2008 Feb 29 01:35 PM

[Geronimo:]

The GSE's guarantee loans they don't originate, and therefore don't adequately understand. The originators are in a better position to understand the loans, but don't care enough about loan quality because to loans are sold without recourse.

Requiring all loan sales to GSE's to be with recourse would do much to solve the associated problems.

2008 Feb 29 05:47 PM

[pt:]

The increase in the size of the maximum loan that can be guaranteed by the GSEs is scheduled to end 12/31/2008, but everyone knows that the end-date will be extended to prop up home prices. Have you ever seen a large government program paying off millions of voters be eliminated?

2008 Mar 01 07:41 AM

[jerry p:]

It's funny to see that some people are still comparing past default rates to the loans of the past few years. Alt-A used to be very safe loans until the lenders threw all standards out the window. Subprime used to default at under 5% and is now defaulting at nearly 20%. One jumbo loans default equals three or more average conforming loans defaulting. Now throw on a housing bubble where prices will drop 20-30 percent with jumbo defaults and you have a recipe for disaster

2008 Mar 01 08:38 PM

[RobKBlakeblows:]

Rob K Blake is a joke. Why your website would put his bush league BS in it is beyond me. C'mon, you're better than that.

2008 Mar 01 09:06 PM

[Freefalling:]

Sorry Rick, but 'Left Coast' says you got skin in the game in Jumbo-land so you have a very strong bias here. Jumbo's require the ponzi scheme to keep going as not enough people make enough money to buy them all. Sad but mostly true--this was Feb, now it's July and they were both bailed out. Care to temper your opinion in hindsight?

2008 Jul 28 04:33 PM