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Fannie and Freddie Drop the Bomb

Written By Brian Hicks

Posted July 19, 2007

As we have said so many times before in these pages, watching the government do practically anything is akin to watching molasses run down he hill in January. But as slow as that bureaucratic morass is, when it finally does manage to make a decision with some real weight, it comes crashing down like a massive hammer.

That at least was the sound heard last Friday when the Office of Federal Housing Enterprise Oversight (OFHEO) finally forced Fannie Mae and Freddie Mac to comply with the Interagency Guidance on Nontraditional Mortgage Product Risks introduced last fall.

It’s the OFHEO that is responsible for overseeing the operations of the two privately owned but government sponsored enterprises (GSEs), otherwise known as Freddie and Fannie. Between them, they hold some $1.5 trillion in mortgages and mortgage backed securities.

It was those guidelines, you may remember, that dealt with what came to be known as "exotic" or "toxic" mortgages.

The new guidelines demanded that any mortgage containing an interest-only feature be underwritten at the highest possible interest rate or subsequent amortizing payment, and that any mortgage containing a negative-amortizing feature (an option ARM) be underwritten at the highest possible balance and interest-rate adjustment.

In short, what they tried to do was bring a little sanity to a segment of the industry that sorely needed it. In a stroke of brilliance, the regulators decided that it would be a good idea for underwriters to actually consider a borrowers’ ability to repay the loan beyond the first year. What a concept.

But despite that common sense approach to mortgage finance, those guidelines have gone largely ignored by the biggest buyers of mortgage paper– Freddie and Fannie– even though both of them were ordered to comply with the new rules only last February.

That stare down, however, came to end last Friday, which fittingly enough also turned out to be the 13th. That’s when the two mortgage giants finally blinked and informed their customers of the ensuing changes in their underwriting standards.

Additionally, they both also indicated that they would begin to implement a program in the future to address their sub prime standards, in move to become compliant the regulators Statement on Sub Prime Mortgage Lending.

That means that compliance with those "guidelines" will now become mandatory for any mortgage bought by either enterprise with an application date on or after of September 13, 2007.

And while all of that may seem like nothing more than some fancy mortgage lingo, in practice it fell on already weakening housing market like 500lb. bomb.

That’s because now that Freddie and Fannie actually do have to follow the rules, it means that considerably fewer borrowers will now be able to qualify for a home loan. And when they do qualify it will be at much smaller loan amounts.

That, of course, spells nothing but doom for the borrowers that had to use these types of products to qualify in the first place because that option now has been severely limited by the new regulations.

Unfortunately, many borrowers will now find themselves completely trapped and unable to refinance as a result.

All of this, of course, couldn’t come at a worse time for the industry as against the weight of fast rising foreclosures, which can now only get worse.

In fact, foreclosures are up 87 percent nationwide above last June’s pace, with one filing for every 704 households, according to a monthly report by RealtyTrac.

"The outlook isn’t terribly optimistic for the rest of this year," Rick Sharga, RealtyTrac’s vice president of marketing, said in an interview.

"There are, depending on whose numbers you believe, somewhere between $600 million and $1 billion worth of adjustable-rate mortgages that are going to reset in the second half," he said. "We anticipate a fair number of those are going to go into default, so we really do expect probably to see another spike in the fall," Sharga added referring to new foreclosures.

That, of course, makes for a lot of people struggling to keep their heads above water-many of whom that just had their life preservers yanked away from them.

This is really going to get ugly.

By the Way: Homebuilder sentiment slid in July to its lowest since January 1991 as the fallout from the housing slump and sub prime mortgage crisis led to a further a glut of new homes, the National Association of Home Builders said on Tuesday.

"The bottom line is that the single-family housing market is still in a correction process following the historic and unsustainable highs of the 2003-2005 period," NAHB Chief Economist David Seiders said in the statement.

The NAHB/Wells Fargo Housing Market index fell to 24 from 28 in June, the group said in a statement. Readings below 50 mean more builders view the market conditions as poor rather than favorable.

Bear Stearns Update:

Bear Stearns Cos. told its investors in two failed hedge funds on Tuesday that they will get little if any money back after “unprecedented declines” in the value of AAA rated securities used to bet on subprime mortgages.

Estimates show there is “effectively no value left” in the High-Grade Structured Credit Strategies Enhanced Leverage Fund and “very little value left” in the High-Grade Structured Credit Strategies Fund, Bear Stearns said in a two-page letter.

This is a watershed,” said Sean Egan, managing director of Egan-Jones Ratings Co. in Haverford, Pennsylvania. A leading player, which has honed a reputation as a sage investor in mortgage securities, has faltered. It begs the question of how other market participants have fared.”

It begs the question, indeed.

The mortgage morass has now claimed 100 major U.S. lenders since December 2006.


Wishing you happiness, health and wealth,


Steve Christ, Editor