By Mark Griffith Mortgage Investors Group Branch Manager- Oak Ridge Co-Host of The Housing Hour
The Rise of the GSEs
When the smoke finally cleared from the destruction of the S&L’s in the late 80’s early 90’s, FNMA and Freddie Mac were solidly in place. It took 36 years for Roosevelt’s national liquidity vision to be realized. The ’90s brought the hope of a new mortgage lending era with cutting edge technologies and an internet system that connected the world. FNMA and Freddie Mac incorporated the national credit scoring system along with property valuation models into their automated underwriting systems (AUS) to produce a streamlined approval process. This total automated system was intended to take all the guesswork out of analyzing risk, which in turn, would reduce costs of originating and selling loans. These cost savings could be passed through to the consumer in the form of cheaper interest rates and closing costs, as well as eventually finding their way into the profits of lenders, FNMA/Freddie Mac, bond traders and ultimately the end investor. The other important feature was the complete automated nature of the system with its ability to expand or contract its guideline through simple tweaking of the computer models. In the early ’90s, pressure from the Clinton administration for a National Home Ownership Strategy was developed. This complete housing overhaul consisted of over 100 action items and over 50 industry-wide corporate partnerships signing their support. The new initiative was known as the American Dream Commitment. By 2004, continued expansion of the commitment was evident in FNMA mission statement, “We at Fannie Mae are in the American Dream business. Our mission is to tear down barriers, lower costs, and increase the opportunities for homeownership and affordable rental housing for all Americans”. With this new mantra and fresh momentum, backed by policymakers and trillions of dollars, the housing bubble years were inflating. The most aggressive part of the mission statement from FNMA was, ‘…tear down barriers…’ and ‘…for all Americans.’. The barriers could be easily torn down by simple manipulation of the automated systems resulting in achieving the second point, more Americans becoming eligible for mortgage loans almost overnight.
In the past, FNMA/Freddie Mac were always known as the world supplier of ‘AAA rated’ Mortgage Backed Securities meaning the best loans available for securitization, the cream of the crop. They were referred to in the vernacular as: ‘A’ paper or prime paper. By Y2K, FNMA/Freddie Mac entered the less than prime business called Alt-A or A minus. Alt-A is defined as not A paper but better than C through D paper. There were private lenders who did specialize in loans referred to as: non-traditional, ‘C/D’ paper or the popular term, sub-prime, but these loans were considered high risk, niche products. The sub-prime market could charge higher interest rates and more closing costs depending on the degree of risk to the lender. However, by the late ’90s, credit scoring models gave the sub-prime lenders an easier ability to analyze risk. These lenders were able to expand their origination numbers by creating automated underwriting systems, similar to FNMA/Freddie Mac, based on their own sub-prime risk criteria.
The sub-prime loans were traded much like the prime loans but through Private-Label Mortgage-backed securities (PL-MBS) as created by the 1984 Secondary Mortgage Market Security Act(SMMSA). The SMMSA was a loosely government created policy allowing private institutional investors more freedom to compete in the Government dominated MBS markets. The SMMSA was basically an attempt to supply private liquidity to investors for the national liquidity markets. In a similar sense, the Private-Label -MBS were what the S&Ls were to the liquidity market before their fall, except for the fact the Private -Label MBS were securitized and traded worldwide. Investors with large appetites for higher interest returns flocked to the sub-prime markets. In 2001, the Private-Label MBS market had a small 20% market share but by 2006 their market share soared to 56%, suggesting the sub-prime primordial world was strongly competing for investment dollars with the conforming loan markets. Pressure for profits and from government policies propelled FNMA/Freddie Mac to review its policy on the purchase of Private-Label MBS bonds.
As early as 2001, FNMA/Freddie Mac were purchasing sub-prime mortgages from the Private-Label MBS pools. But according to The Financial Crisis Inquiry Report, FNMA’s purchase of sub-prime loans only represented a relatively small 10.5% of total sub-prime loans originated. By 2004, FNMA exposure rose to a 40% high before dropping back to 28% by 2008.
However, between 2001 and 2008 FNMA/Freddie Mac significantly dropped their guidelines to allow riskier loans to be purchased and securitized by the GSEs. In a 2 year span between 2005 and 2007, FNMA/Freddie Mac had purchased close to a trillion dollars in Alt-A and sub-prime loans; a level that could not be sustained. Private-Label MBS had decreased to less than 10% market share in 2008 but by that time, the worlds financial markets were flooded with assets that would soon turn toxic.
As reported in the Inquiry, FNMA and Freddie Mac were motivated by a need, “to meet stock market analysts’ and investors’ expectations for growth, to regain market share, and to ensure generous compensation for their executives and employees—justifying their activities on the broad and sustained public policy support for homeownership.”
By 2008, the GSEs and the Private-Labels MBS were collapsing.
Part V: The Fall of Fannie and Freddie and the Private Labels
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In the past, FNMA/Freddie Mac were always known as the world supplier of ‘AAA rated’ Mortgage Backed Securities meaning the best loans available for securitization, the cream of the crop. They were referred to in the vernacular as: ‘A’ paper or prime paper. By Y2K, FNMA/Freddie Mac entered the less than prime business called Alt-A or A minus. Alt-A is defined as not A paper but better than C through D paper. There were private lenders who did specialize in loans referred to as: non-traditional, ‘C/D’ paper or the popular term, sub-prime, but these loans were considered high risk, niche products. The sub-prime market could charge higher interest rates and more closing costs depending on the degree of risk to the lender. However, by the late ’90s, credit scoring models gave the sub-prime lenders an easier ability to analyze risk. These lenders were able to expand their origination numbers by creating automated underwriting systems, similar to FNMA/Freddie Mac, based on their own sub-prime risk criteria.
