Bonds Backed By Fannie Mae, Freddie Mac May Decline

Bonds backed by mortgages to the riskiest borrowers may weaken next year as Fannie Mae and Freddie Mac, the largest providers of money for home loans, cut their purchases, according to Bloomberg.com.

Regulators of the government-chartered companies this month told them to tighten standards on “non-traditional mortgage loans” they finance. Waning interest by Fannie Mae and Freddie Mac in the so-called sub-prime loans may boost the yield premium investors demand to own them.

Wider spreads on the top-rated AAA classes of such securities that Fannie Mae and Freddie Mac typically buy may raise mortgage rates for sub-prime borrowers, who have no credit or a bad credit. The housing market slump and the highest level of late payments on sub-prime home loans since 2003 have pushed up spreads on the lower-rated bonds.

Fannie Mae and Freddie Mac, which own about 15 percent of the $10 trillion U.S. market for residential home mortgages, last year bought about $221.3 billion of “non-agency” mortgage securities, or those not issued by them or other government agencies. Assuming all the purchases were of sub-prime mortgage bonds, they bought 37 percent of the total new volume.

The Office of Federal Housing Enterprise Oversight (OFHEO) told Fannie Mae and Freddie Mac on December 8 to create policies on non-traditional loans that mimic what federal regulators asked of banking companies three months ago, including that a mortgage lender assumes borrowers face higher payments than initially required in evaluating consumers’ ability to pay off debt.

Non-traditional loans include the interest-only mortgage and option ARMs, whose minimum payments don’t cover the interest owed. Bank regulators also may require tougher tests for common sub-prime ARMs, with home loan rates that rise after two or three years even without higher market rates, FDIC Sheila Bair said last month.

Congress created Washington-based Fannie Mae and Freddie Mac to expand home ownership by increasing mortgage financing and provide market stability. They earn money by holding assets and through fees for guaranteeing the mortgage securities they create out of home loans bought from lenders.

The seasonally adjusted rate of late payments on sub-prime loans rose last quarter to the highest since the first three months of 2003, climbing 0.93 percentage point from a year earlier to 12.56 percent, the Mortgage Bankers Association said. Even if spreads on AAA sub-prime bonds widen, the credits are still sound.

“I can’t envision anything short of the Great Depression of the 1930s that would bring into question the interest and principal of AAA classes,” said analyst Michael Youngblood of Friedman Billings.

Floating-rate asset-backed securities of sub-prime mortgages and certain home equity loans have returned 5.5 percent this year, according to Merrill Lynch data. Treasury notes and bonds returned 3.5 percent.

Letters from OFHEO to Fannie Mae and Freddie Mac don’t explicitly say they must apply bank regulators’ guidance to bond purchases. The regulator does expect them to develop systems to ensure they avoid buying securities with loans not conforming to the directive.

Some regulators of state banks and lenders, such as Washington’s Department of Financial Institutions and Kentucky’s Office of Financial Institutions, also have told their charges to follow guidelines similar to what the FDIC, Federal Reserve, and other federal bank regulators put out in September.

Sellers of sub-prime bonds to them include Countrywide Mortgage, New Century Financial Corp., H&R Block Inc.’s Option One Mortgage, ACC Capital Holdings’ Ameriquest Mortgage, General Electric Co.’s WMC Mortgage, Fremont General Corp. and Novastar Financial Inc.