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The GSEs Are Being (Very Slowly) Phased Out; Perhaps We Are Seeing The Consequences

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Nick Timiraos wrote a piece in the Wall Street Journal on Thursday about how mortgage rates on loans eligible for Fannie Mae and Freddie Mac purchase are higher than those that are not--loans with balances that exceed the "conforming loan limit" that specifies the maximum size of a loan eligible for GSE purchase. Why did this happen?  How is it that loans backed by a government guarantee cost more than loans without such a guarantee?

There are two reasons: guarantee fees, and availability of credit.

Guarantee fees are fees that Fannie Mae and Freddie Mac charge to guarantee investors that loans they hold will be fully repaid to them: they are essentially an insurance premium.  These fees get passed onto borrowers.  The regulator of Fannie and Freddie, the Federal Housing Finance Agency, has been pushing the GSEs to raise their g-fees, and those fees are around 30-40 basis points higher than they were pre-crisis.  As the fees go up, Fannie and Freddie buys loans that are (1) very profitable and (2) are less competitive.

The consequence of Fannie/Freddie loans becoming more expensive is that the market is becoming more attractive for private providers of mortgage capital, and banks (which are not really purely private, as they have FDIC backing) and private label securities are beginning to crawl back into the mortgage market.  This is an effective method for reducing the footprint of the GSEs in the mortgage market.

But as strong as the underwriting standards have gotten for Fannie/Freddie loans, they are still even tougher for jumbo loans.  Jumbo lenders are generally requiring lower loan-to-value rations, stronger FICO scores, more reserves, and even more documentation than Fannie/Freddie loans.  For example, a recent private label RMBS has loans with an average LTV of 67.5 percent and an average FICO score of 771. These are not prime loans--they are super-prime loans.  So of course these loans have low interest rates; the credit risk associated with them is nearly zero.  Investors judge that the "insurance" they need to set aside for themselves for possible default is lower than the 50-60 basis points being paid to Fannie and Freddie.

But while PLS backed loans come with low prices to consumers, they do not provide access to credit to many credit-worthy borrowers.  That is what might happen if we move to a purely private market.  The interest rates on loans that are originated may be no higher, but the availability of loans may be a lot lower.

[Disclosure: I worked at Freddie Mac From September 2002-January 2004.  As a result, I own some common shares in the company.  I do not think they should ever again have real value].