Friday, May 16, 2008

Risk Of Taxpayers' Bailout Of Fannie Mae Just Increased

Just when you thought: “things couldn’t get any worse.” It just did. According to MSNBC, “Fannie Mae says it is doing away with higher minimum downpayment requirements for borrowers in distressed real estate markets.”

Reducing their minim down payment from 5% to 3% is just the reckless action that Fannie Mae and Freddie Mac should be avoiding at this time. Here is the official excerpt from Fannie Mae:

“Starting June 1, 2008, Fannie Mae will accept up to 97 percent loan-to-value ratios for conventional, conforming mortgages processed through its Desktop Underwriter® (DU®) automated underwriting system, and 95 percent loan-to-value ratios for loans underwritten outside of DU, in all geographic locations in the United States. The new national down payment policy will supersede the policy the company adopted in December 2007 that required higher down payments in markets where home prices are declining.”

What this means is that mortgage banks can use an automated underwriting system to reduce the minimum down payment requirements to 3% instead of the usual 5% minimum. So, what do you think the banks are going to do?

Like you, I expect a tremendous increase in loans filed through the DU automatic underwriting systems.

Here is a heat map of the foreclosure in the U.S., as of April (source: RealtyTrac):

Here is the data from RealtyTrac April 2008 U.S. Foreclosure Market Report™ [bold and italics added for emphasis]: “foreclosure filings — default notices, auction sale notices and bank repossessions — were reported on 243,353 properties, a 4 percent increase from the previous month and a nearly 65 percent increase from April 2007. The report also shows one in every 519 U.S. households received a foreclosure filing during the month.”

With the news that people at all levels of income are defaulting on their mortgage, Fannie Mae and Freddie Mac should be tightening up on their lending standards, especially banning the “piggy-back” loans from qualifying for sale to Fannie Mae. Sadly, this has not been banned; rather, it is highlighted in their May 16 public release [bold and italics added for emphasis]:

“Fannie Mae will continue to provide support for homebuyers that need down payment assistance, and will continue to allow loans with Community Seconds® up to a maximum 105 percent combined loan-to-value ratio. Community Seconds allow a borrower to obtain a second-lien mortgage to help cover down payment and closing costs, with funding typically provided by a state or local housing agency; an employer; or a nonprofit organization. Fannie Mae also offers MyCommunityMortgage® and Flex mortgage products, which permit down payment assistance programs in the form of gifts and grants. “

What this means that the risk of taxpayers bailout of Fannie Mae and Freddie Mac has gone up substantially. I think that the bailout will have to occur as more areas show declining housing value and increased defaults. Since Fannie Mae and Freddie Mac securitize the loans using the implied government guaranty, the ones who will suffer first would be the investors who bought their MBS bonds at initial offering.

As rating agencies begin to negatively assess the Fannie Mae and Freddie Mac issued MBS traunches, prices of these bonds will go down. This will set the stage for the taxpayer bailout since Fannie Mae and Freddie Mac have very low reserve, thanks to the OFHEO reducing the capital reserve requirements in March. I wrote about this as being a potential liability to the taxpayers in my write up “Fannie And Freddie Reduces Capital Reserve: Risk Of Taxpayer Bailout Just Increased.”

In that article, I estimated that the taxpayers would be liable for potentially $20.6 billion in bailout. However, with this news, the amount of the liability will go higher. How much higher would be determined by the assessing the increase year-over-year of mortgage origination, beginning in June. Hopefully, the banks that are selling the mortgages to Fannie Mae and Freddie Mac will continue to use stricter underwriting and realistic appraised value, thereby reducing the potentiality of the risk.

We will keep an eye out on this issue, as it develops.

Have a great weekend!

Ed Kim
Practical Risk Manager

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