Thursday, February 07, 2008

Lockhart: No Jumbos Without More Oversight

by Tanta on 2/07/2008 10:36:00 AM

Seems like a fair request to me. This is from OFHEO Director James Lockhart's testimony to the Senate Banking Committee, link brought to you by the indefatigable and industrious bacon dreamz:

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. . . .

The risks are beginning to take their toll. Public disclosures indicate that Freddie Mac will report annual losses for the first time in its history and Fannie Mae for the first time in 22 years. Their missions, as well as Congressional and many other pressures, are demanding that they do more and take on more risks in areas new to them – subprime and jumbo mortgages. As the safety and soundness regulator of Fannie Mae and Freddie Mac, I have to tell you that expansion of their activities would be imprudent unless the regulator has significantly more powers and more flexibility to use those powers. Given the tremendous stresses on the mortgage markets, the American people cannot afford to have Fannie Mae, Freddie Mac, or the 12 FHLBanks incapable of serving their mission. . . .

In 2006, Fannie Mae and Freddie Mac were losing market share to Wall Street private label MBS (PLS). There is a certain irony that one of the ways they prevented their market share from falling even farther was that they became the biggest buyers of the AAA tranches subprime and Alt-A of these PLS. The Enterprises’ earlier problems, OFHEO’s constraints, and the loose underwriting standards in the market made it hard for them to compete. Some observers even suggested that, due to shrinking of market share, their support of, and therefore their risk to, the mortgage market were no longer relevant.

In the last half of 2007, the PLS world shrunk to minimal levels as a result of a long list of well reported problems. As a result, even with the OFHEO constraints, Fannie Mae and Freddie Mac mortgage purchases as a share of new originations grew to unforeseen levels, rising from less than 38 percent in 2006 to over 60 percent in the third quarter of 2007. The just reported fourth quarter results of 75.6 percent are double 2006’s market share. If you add in the net increase in outstanding FHLBank advances, especially in the third quarter, the combined market share of the housing GSEs may be 90 percent. . . .

Another related change over the period was the growth of credit risk. Operational risk and to a lesser extent market risk had been the key focuses of the Enterprises and they still are extremely important with the volatility of the markets and heavy reliance on models for market and credit risk pricing. I remember listing credit risk concerns in an early presentation I did to one of their Boards. Some members were mystified that I thought it was an issue given their track record. I am afraid that was a sign of the times.

The Enterprises were then reporting credit losses of 1 to 2 basis points, a third of normal levels and now they are approaching double normal levels and climbing. Some of this growth in losses was because they lowered underwriting standards in late 2005, 2006, and the first half of 2007 by buying more non-traditional mortgages to retain market share and compete in the affordable market. They also have very large counterparty risks including seller/servicers, mortgage insurers, bond insurers and derivative issuers.

Basis points sound small, but they become important when you are leveraged the way Fannie Mae and Freddie Mac are . . .

Now, I will turn to the temporary increase in the Conforming Loan Limit (CLL) as proposed in the Economic Stimulus package. OFHEO believes any increase in the CLL should be coupled with quick enactment of comprehensive GSE reform. The CLL provision in the stimulus package would increase the Enterprises risks by allowing them to enter the “jumbo” loan market. It would increase the maximum size loan those GSEs could purchase or guarantee from $417,000, to the lower of 125 percent of median area prices or $730,000, for mortgages originated between July 1, 2007 and December 31, 2008. This change should help lower interest rates on some jumbo mortgages, but other potential implications deserve attention.

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. . .