Three separate events had significant impact on mortgage markets last week.  The Home Protection bill is being debated. IndyMac Bank announced it was closing it wholesale operations. Then on Friday the bank was taken over by federal regulators. Finally Fannie Mae and Freddie Mae stock values dropped by nearly 50% amid concerns over the two companies ability to maintain their capitalization requirements necessary to meet their obligations.

It was quite a week.

Sunday the Treasury Department announced that the Federal Reserve and the Treasury department would step in with measures that would ease short term capital requirements.

•1.       The Federal Reserve opened discount lending to Fannie and Freddie.

•2.       The Treasury department would request an increase in the existing $2.5 billion line of credit.

•3.       The Treasury  Department would request the ability to purchase stock in the two companies.

•4.       An increased federal oversight into the management of the two companies is also proposed.

Today, markets seemed to respond fairly well to these proposed actions. A good sign is that the morning auction of $3 billion in Freddie Mac securities went well.

Two concerns exist. One is investor confidence to lend Fannie Mae and Freddie Mac necessary short term funds and to purchase mortgage back securities. It is the guarantee of the mortgage securities that makes these investments attractive. Investors must trust the guarantee. If not, they either will not purchase them or will require higher interest rates. This would push mortgage rates higher.

The other concern is more long term and significant - Whether Fannie Mae and Freddie Mac actually have and will continue to have sufficient capital reserves to stay in business. Investor confidence can be restored. If the actual capital reserves are insufficient, it will take real money to restore them, and perhaps real changes to the structure of both companies.

Capital reserves come from existing assets, monthly income, loans, and equity investment. The latter is hurt by the drop in stock value.

Reserves are drained by losses. To date $11 billion combined losses are reported. It is unknown the extent of future losses, but estimates range from $24 billion to $300 billion.

To reduce losses lending guidelines are being tightened and risk based pricing has been instituted. What other changes are being considered?

The cause of the losses has not been discussed in news coverage. The typical interview with experts moves from Fannie and Freddie losses to a discussion of subprime lending woes. Fannie and Freddie did not guarantee subprime loans.

I have heard bad loans mentioned a few times, but were the loans bad,  speaking of conventional loans? Were the guidelines too lax? Was underwriting too lax? This would likely mean a significant shift in underwriting guidelines, more than has already taken place. This may have begun with the Federal Reserve's new guidelines prohibiting loans that do not prove of income.

This by the way could likely have a significant impact in the ability of good credit, self employed borrowers. I have not seen the details of the new rules or the time frame for implementation. The actual remarks and the reports indicate that the focus of the new guidelines is strictly "high priced loans."

Here is the text of the comments. 

Here is Reuters' article on the speech about "deceptive mortgage practices." The headline itself indicates that the prevailing belief that the fault of the mortgage crisis is that evil lenders deceived unwitting consumers. I am not sure that is correct. I am sure it is not objective reporting. All of the practices being addressed are not deceptive and are not designed to trap unwitting home owners. the article uses phrases such as "lure", "aggressive practices", (misleading) "promises".

I am not sure what impact this change will have. For the most part, the market itself has stopped the subprime lending that is targetted in the remarks.

Is the problem more of an economic issue? If so then the fix might require a different solution, and the fault of the foreclosure trends might not be so fully on bad lending practices.

I understand the significance of these defaults of conventional loans. I just do not understand their cause.

Richard Smith
Home financing in Tennessee, Georgia, and Alabama.
Experience matters when it is your home loan.