Jumbo Mortgage Risk Will Topple A Tettering Fannie Mae & Freddie Mac

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When President Bush signed the Economic Stimulus Act into law making jumbo mortgages GSE insurable, he may have unwittingly pushed our GSEs, Fannie Mae and Freddie Mac, already on tilt, over the edge. If you think we have a housing crisis now, wait until you see what the demise of the GSEs and subsequent secondary mortgage market would do!

Let’s start with a few facts here to bring you up to speed on all the players and the game.

First, we have the GSEs: Fannie Mae and Freddie Mac who for all practical purposes create and dominate our “prime” credit, full documentation, conforming loan limit (upto $417,000), bread and butter, mortgage products. They are considered “quasi-government” organizations but are really just NYSE traded companies with much more responsibility since they insure mortgage loans so they can be “pooled” and sold to Wall Street.

With Wall Street ready and eager to buy anything “insured” by the government, we all now enjoy a virtually limitless source of mortgage money. When mortgage money is readily available, the housing market is helped…and conversely, a lack of mortgage money hurts the housing market. Of course this was the sole reason in the beginning for the GSE’s; to support the housing market by maintain a sound but liquid secondary mortgage market.

Second, the Office of Federal Housing Enterprise Oversight (OFHEO), the closest thing Fannie Mae and Freddie Mac have to a regulator. OFHEO became more important as both GSE’s had a few “accounting scandals” ala Enron a few years back. Moving forward the have more often than not been the “voice of reason” when it comes to keeping the GSE’s in check.

Since private mortgage insurers like PMI, MGIC, and Radian, are recently coming under suspicion for being on the brink of collapse, it’s only prudent to ask are the “public” versions of mortgage insurers - the GSE’s - feeling the same pinch. The recent scandals and the subprime meltdown as they effect GSE solvency are all concerns for the OFHEO.

Third, we have Congress. Specifically, ranking members in both House and Senate Banking Committees who are also supposed to be concerned with maintaining a viable secondary mortgage market, but really respond more to the huge campaign contributions Fannie Mae and Freddie Mac are known for throwing around to get their way.

So now the stage is set with the players, let’s see how they interact.

The GSE’s are stock-holder owned private companies who are just as worried about next quarter’s stock price as any publicly traded company. Even thought they are entrusted with our nation’s mortgage market solvency, they may have another more pressing agenda. They pass out campaign contributions to both sides of the isle like so much candy to get favorable legislation passed and to keep regulations from holding back their “growth”.

Fannie Mae stock over the last 30 years has returned for it’s investor’s a 20,000% return…simply staggering!

Their regulator, the OFHEO, is funded by Congress so by proxy assuming quid pro quo, FNMA controls it’s own regulators purse strings…not good.

Enter the Bush Administration Stimulus Package…

Inside the newly passed Economic Stimulus Act of 2008 contained a provision to increase the loan limit the GSEs could insure from $417,000 up to $729,750 making a formerly jumbo mortgage temporarily a conforming loan. This can apply to all jumbo loans made from July 31, 2007 to December 31, 2008.

Before the Bush Stimulus Package, the administration was adamant about not allowing an increase in conforming loan limits until Congress tackled full fledged GSE reform. They caved in to this OFHEO recommended safeguard to speed up the process of getting checks in the hands of eager consumers. A decision we may all some day regret.

In OFHEO Director, Mr. Lockhart’s words before the Senate Banking, Housing and Urban Affairs Committee on February 7, 2008, just days before the Stimulus Act was made law,

“Jumbo loans would present new risks to the already challenged GSEs. The prepayment and credit risks are different than those of conforming loans. The provision also pushes the GSEs to increase their geographic concentration in some of the riskiest real estate markets.

Roughly half of all jumbos are in California. Underwriting them successfully will require new models and systems to ensure safe and sound implementation. Capital also would present challenges even if all newly conforming mortgages are securitized. A $600,000 loan requires as much capital as three $200,000 loans.”

I contacted the OFHEO and got a media representative on the phone in the hopes they would comment on what the Director meant by “new models and systems to ensure safe and sound implementation”.

I got a perfunctory, “We’ll call you back”… as of post time no call back was received.

So here we go again. The GSE’s want some legislation that will help their bottom line but possibly put the solvency of our secondary market in danger…and they get it…over the voiced opposition of their own regulator.

In the same hearing, Mr. Lockhart reported some outlandish and worrisome facts:

“Measured this way, each Enterprise’s leverage increased dramatically in the first nine months of 2007, exceeding 80 times their fair value of equity as of September 30th. Or if you look at it the other way around, there is only 1.2 percent of equity backing their mortgage exposure.

For the first three quarters of 2007, they have each lost $8 to $9 billion in fair value of equity. Their combined fair value equity at the end of the third quarter was $58 billion compared to $5.1 trillion in mortgage exposure.”

This is astonishing. Talk about a company on tilt. The GSE’s combined have a little over a penny for every $1 of exposure!

And yet every MBS they issue would still be given a AAA rating…including these new “jumbo mortgage” masquerading as conforming securities.

Lockhart summarizes nicely,

“The GSEs have become the dominant funding mechanism for the entire mortgage system in these troubling times. They are fulfilling their missions of providing liquidity, stability, and affordability to the mortgage markets. In doing so, they have been reducing risks in the market, but concentrating mortgage risks on themselves.”

Only Time Will Tell

I did reach John Hildreth, a lobbyist for the Credit Union Nation Association after reading a cogent article of his on GSE reform. I asked him about his take on whether increasing conforming loan limits given the increased risk “jumbo” loans posses was a “smart” move by the Bush Administration.

His reply was, “I’m not an economist. I’m a lobbyist. But my guess is only time will tell”.

Unlike Mr. Hildreth, I’m more prone to jump to a negative conclusion when it comes to the unmitigated greed of Fannie Mae and to a lesser degree Freddie Mac. I suspect there will be negative ramifications allowing a company whose losing money faster than it can count take on more risk, bigger risk, without the proper safeguards. After all it does sound eerily close the recent subprime debacle or the more distant savings and loan debacle.

But maybe the built-in temporary status of these changes allowing jumbo loans into the mix, will be a saving grace.

I’ll be holding my breath until December 31, 2008. It can’t come fast enough for me.

Good Luck!

Author: Rob K. Blake
Published February 21, 2008
Modified March 4, 2008

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