Fannie Mae, Freddie Mac Grow Mortgage Bond Share

One interesting side effect of the bad credit home loan meltdown: the old guard is making a comeback.
Thanks to the recent surge in delinquencies and defaults on subprime (bad credit) mortgage loans, lenders to borrowers with poor credit are finding that kittish Wall Street investors are willing to offer lower prices for their loans these days.

Housing finance agencies Fannie Mae and Freddie Mac are stepping up and offering better prices to guarantee timely payment of both interest and principal on subprime loan pools, as well as loans to Alt-A borrowers - those who fall short of prime status, but above subprime.

As a result, the agencies, which provide liquidity to the home mortgage market by buying pools of loans as well as guaranteeing them - are grabbing a larger share of the overall market for mortgage securities.

The share of mortgage bonds issued by Fannie Mae and Freddie Mac stood at 49 percent of overall mortgage bond issuance as of March, according to a recent UBS report, up from 44 percent in 2006.

The agency share of total mortgage bond issuance was 78 percent in 2003, according to UBS, ranging from 75 percent to 85 percent from 1995-2003.

The housing finance agencies lost market share to so-called private-label issuers - mainly commercial and investment banks - starting in 2004.

That was when housing prices began to skyrocket, causing lenders to ease credit terms and experiment with innovative underwriting including allowing borrowers with low credit scores to buy homes making no down payment and stated income, rather than documented proof.

But that loose underwriting has now begun to reverse itself after banks saw a wave of early defaults for loans made to borrowers with bad credit.

With the swing back toward tighter lending standards, the finance agencies are more than happy to take the opportunity to expand their market share, after watching it diminish so sharply in the past several years.

“We have seen an uptick,” in the number of loans to borrowers with lower credit scores and smaller down payments, said Bob Ryan, vice president in charge of single-family loan pricing for Freddie Mac.

Ryan noted that Freddie Mac has been guaranteeing what it calls the market for “A-minus” home loans since at least the early 2000s.

The program refers to the home loans made to borrowers with less than perfect credit, but who would still be considered at the higher end of subprime or Alt-A mortgage lending.

The agencies are still steering clear of the riskiest loans. As a general rule, Freddie Mac tends to reject loans to borrowers that have credit scores below 600, who are also stating (not documenting) their income and for which borrowers have very little or no money to put down as a down payment.

Such combined risks, which became common in home loan products issued to subprime as well as some Alt-A borrowers in 2005 and 2006, have since been shown to raise the likelihood of borrower default.

Mortgage bond investors seem mostly to welcome having the housing finance agencies play a larger role in the subprime and Alt-A mortgage markets.

Agency-guaranteed bonds backed by these loans tend to carry high coupons, which can be especially favorable in a slower housing market, said Scott Kirby, a portfolio manager for RiverSource Investments.

That’s because borrowers with slightly imperfect credit scores and lower equity in their homes tend to apply for mortgage refinancing at a much slower pace than borrowers a little higher up the credit scale.

That means investors in these bonds can count on collecting their high coupons for a lot longer without worrying that loans will undergo mortgage refinance activity.

Kirby said his group looks for agency home loan bonds with particular, specifically favorable characteristics - high coupon, low probability of too many refinancings - all the time.

“That’s a very significant part of our pass-through mortgage strategy,” he said. RiverSource Investments has about $100 billion in fixed-income assets under management.

Having more supply of agency guaranteed mortgage bonds backed by specific types of loans to lower-credit borrowers is also helpful to investors who may have had trouble finding such bonds in the past.

And it also helps investors who weren’t sure how to price such bonds when they were available, said Matt MacDonald, a fixed-income portfolio manager for Deutsche Asset Management in New York.

When supply of mortgage bonds with very specific mortgage loan characteristics is scarce, it makes pricing less than transparent, MacDonald added.

Before Fannie Mae and Freddie Mac made their current push, it was difficult to find bonds guaranteed by the agencies and backed by subprime and Alt-A.

Even though in the short run investors in mortgage bonds might be concerned that extra supply could cause bond prices in the sector generally to go a bit lower, “in the agency market it’s a small positive,” to have Fannie Mae and Freddie Mac guaranteeing more loans from borrowers of Alt-A and bad credit home loans.

SOURCE: Houston Chronicle