Freddie Mac: Final Nail in the Coffin of Interest-Only Mortgages?

| About: Freddie Mac (FMCC)
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Freddie Mac (FRE) announced today that it would no longer purchase or securitize interest-only loans, in a move that just makes you wonder, what took so long? The government-sponsored entity is the second largest purchaser of U.S. residential mortgages and has dealt with very underachieving performance of these interest only (IO) mortgages. At last count, Freddie had $130 billion in unpaid principal on these IO loans, or 7% of their overall portfolio. Of those loans, 18% of them are considered seriously delinquent or more than 90 days past due. Only at a government sponsored “zombie” would it take $23.4 billion in delinquencies to discover that the business should stop exposing itself to the same risks again and again.

For those unfamiliar with interest-only loans, in general it is a mortgage that the borrower agrees to only pay the interest on the debt for a set period of time, normally five or ten years. At the end of the interest-only period, the mortgage payment “balloons” because the borrower must begin paying off the principal as well as the interest. Many times, the purpose of such a loan is for a person who wants to buy a house and believes their future income will increase to cover the payments that otherwise they would not be able to afford. It is easy to understand why these loans get a lot of the blame for inflating the housing bubble. Obviously, the problem arises when the borrower’s income does not meet their expectations, or as is all too common these days, it disappears entirely. Furthermore, this type of loan can be particularly destructive when the housing market falls because there has been no dent made in the principal amount, so a home owner can be “underwater” more quickly.

“This change is another step in our efforts to refine our mortgage credit and purchase requirements to promote responsible lending and sustainable homeownership,” Freddie Mac spokesman Michael Cosgrove said.

About 14% of the loans had credit enhancements, according to the company. The average unpaid principal balance per loan was $254,601, Freddie Mac said. — 2/26/2010

With the prevailing conditions in the housing and labor markets, we cannot imagine that mortgage loan officers were often allowed to float these kinds of notes very often. Underwriting standards have necessarily become stricter since the housing bubble burst, and borrowers are often required to have substantial down payments. However, if the GSE’s are no longer willing to buy up these IO mortgages on the secondary market, there are certainly few banks willing to take the risk of getting stuck with more non-performing loans. This is not to say that the IO loan is dead and gone forever, but at least for now Freddie Mac is doing its part to kill this relic of a bygone era.

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