Deteriorating Lending Standards at Fan and Fred

May 17, 2008 – 7:52 pm

Does anyone remember when Fan and Fred were still thought to be “prudent” lenders? Relative to the CFCs and WMs of the world they may always have been, but they still have far more risk in their portfolios than they should given the taxpayer guarantee backstopping their balance sheets.

The WSJ reported two days ago (sorry I’m getting around to this late) that Fan and Fred have decided to scrap a rule that required higher down payments for mortgages in markets that were experiencing especially large price declines.

Why the change in policy?

The change comes in response to protests from vital political allies of the government-sponsored provider of funding for mortgages, including the National Association of Realtors, the National Association of Home Builders and organizations that promote affordable housing for low-income people.

Those various groups have said the policy is hurting an already feeble housing market by shutting out too many potential buyers.

Too many overlevered and unqualified borrowers were the problem that expanded the housing bubble in the first place. When lenders require no down payment and are offering low teaser rates, it makes sense for borrowers to take on debt to buy a house. Their mortgage amounts to a free call option on continued house price appreciation.

The policy that “NAR/NAHB/political allies” were protesting was the following:

The current policy, adopted in December and now due to end June 1, limits loan amounts in areas with declining home prices, including most of the densely populated parts of the country.

For instance, if a loan program normally allows people to borrow up to 100% of the estimated property value, the maximum is cut to 95% in “declining markets.”

And the result of ending this policy?

By softening the down-payment policies, Fannie and Freddie are taking more risks.

Borrowers who put just 3% to 5% down in many areas are likely to find within a year that they owe more than the homes are worth because prices have fallen, a situation known as being underwater.

In some cases, deeply underwater borrowers are choosing to walk away from their homes rather than trying to find a way to keep on paying, Patricia Cook, Freddie’s chief business officer, told analysts this week.

Does anyone recall the days when a 20% down payment was the norm? It’s not a bad idea to have borrowers with skin in the game in the form of substantial equity.

A final, and crucial, analytical point made in the article:

The concessions from Fannie and Freddie illustrate the conflicting pressures that they are facing. Many critics say they are taking far too many risks, increasing the danger that taxpayers may end up having to bail them out.

But politicians and the housing industry are pushing them to do more to prop up the housing market.

In a recent letter sent to Fannie and Freddie, the Realtors reminded the companies that the trade group in recent years helped them fend off Bush administration attempts to impose tighter regulatory constraints.

Fannie and Freddie may need the Realtors’ lobbying support in the weeks ahead as Congress seeks to give final approval to long stalled legislation designed to improve regulation of the two companies.

You can’t prop up the housing market forever. Prices have to return to a level where the market clears, where buyers and sellers can agree on a price. We’re a long way from that point as obnoxiously high inventories continue to remind us.

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