Freddie Mac - Business - The Mortgage Crisis From Late 2007

The Mortgage Crisis From Late 2007

Following their mission to meet federal Housing and Urban Development (HUD) housing goals, GSEs such as Fannie Mae, Freddie Mac and the Federal Home Loan Banks (FHLBanks) have striven to improve home ownership of low and middle income families, underserved areas, and generally through special affordable methods such as "the ability to obtain a 30-year fixed-rate mortgage with a low down payment... and the continuous availability of mortgage credit under a wide range of economic conditions." (HUD 2002 Annual Housing Activities Report) Then in 2003-2004, the subprime mortgage crisis began. The market shifted away from regulated GSEs and radically toward Mortgage Backed Securities (MBS) issued by unregulated private-label securitization conduits, typically operated by investment banks.

As mortgage originators began to distribute more and more of their loans through private label MBS, GSEs lost the ability to monitor and control mortgage originators. Competition between the GSEs and private securitizers for loans further undermined GSEs power and strengthened mortgage originators. This contributed to a decline in underwriting standards and was a major cause of the financial crisis.

Investment bank securitizers were more willing to securitize risky loans because they generally retained minimal risk. Whereas the GSEs guaranteed the performance of their MBS, private securitizers generally did not, and might only retain a thin slice of risk. Often, banks would offload this risk to insurance companies or other counterparties through credit default swaps, making their actual risk exposures extremely difficult for investors and creditors to discern.

The shift toward riskier mortgages and private label MBS distribution occurred as financial institutions sought to maintain earnings levels that had been elevated during 2001-2003 by an unprecedented refinancing boom due to historically low interest rates. Earnings depended on volume, so maintaining elevated earnings levels necessitated expanding the borrower pool using lower underwriting standards and new products that the GSEs would not (initially) securitize. Thus, the shift away from GSE securitization to private-label securitization (PLS) also corresponded with a shift in mortgage product type, from traditional, amortizing, fixed-rate mortgages (FRMs) to nontraditional, structurally riskier, nonamortizing, adjustable-rate mortgages (ARMs), and in the start of a sharp deterioration in mortgage underwriting standards. The growth of PLS, however, forced the GSEs to lower their underwriting standards in an attempt to reclaim lost market share to please their private shareholders. Shareholder pressure pushed the GSEs into competition with PLS for market share, and the GSEs loosened their guarantee business underwriting standards in order to compete. In contrast, the wholly public FHA/Ginnie Mae maintained their underwriting standards and instead ceded market share.

The growth of private-label securitization and lack of regulation in this part of the market resulted in the oversupply of underpriced housing finance that led, in 2006, to an increasing number of borrowers, often with poor credit, who were unable to pay their mortgages - particularly with adjustable rate mortgages (ARM), caused a precipitous increase in home foreclosures. As a result, home prices declined as increasing foreclosures added to the already large inventory of homes and stricter lending standards made it more and more difficult for borrowers to get mortgages. This depreciation in home prices led to growing losses for the GSEs, which back the majority of US mortgages. In July 2008, the government attempted to ease market fears by reiterating their view that "Fannie Mae and Freddie Mac play a central role in the US housing finance system". The US Treasury Department and the Federal Reserve took steps to bolster confidence in the corporations, including granting both corporations access to Federal Reserve low-interest loans (at similar rates as commercial banks) and removing the prohibition on the Treasury Department to purchase the GSEs' stock. Despite these efforts, by August 2008, shares of both Fannie Mae and Freddie Mac had tumbled more than 90% from their one-year prior levels.

On Oct 21, 2010 FHFA estimates revealed that the bailout of Freddie Mac and Fannie Mae will likely cost taxpayers $224–360 billion in total, with over $150 billion already provided.

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