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For the next three years fannie and freddie’s risky

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Unformatted text preview: For the next three years, Fannie and Freddie’s risky lending and private label mortgage-backed security purchases (in terms of FICO<660) went from $76 billion in 2000 to $175 billion in 2001 to $244 billion in 2002, with a 50% market share. 31 2.3 Crossing the Rubicon The Rubicon River marks the boundary between the province of Gaul and Italy. It was Roman law that no general could cross this boundary southward towards Rome with his army, lest the general be mistaken for instigating a coup d’état. On January 10, 49 BC, Julius Caesar did just that, stating the infamous words “alea jacta est” (the die is cast). And history was forever changed. The entry of Fannie and Freddie into high-risk mortgages had a similar effect. The primary concern of their critics had been that of interest rate risk: Both GSEs held hundreds of billions of dollars of long-term fixed-rate mortgages in their portfolios. They funded these mortgages to a large extent with debt that had shorter maturities. Both GSEs claimed that they had engaged in derivative (interest rate swaps and options) transactions so as to eliminate any significant interest-rate risk from their overall asset-liability positions. But the specifics of the hedging were murky, and critics were doubtful. At the same time, however, the credit risks on the mortgages that the GSEs bought (and either held or securitized) were not considered a problem. The GSEs had a reputation for high underwriting standards, and their loss experiences supported this view. Except for a few years in the early 1970s for Freddie Mac, the credit loss experience of the GSEs had always been below the “guarantee fees” that they were charging on the MBS that they issued. This observation ignored two important facts: 1. Prior to the mid 1990s, the GSEs only guaranteed safe conforming mortgages with generally low LTVs, good income coverage, and borrowers with high credit scores. So, even with small-to-medium downturns in the economy, mortgage defaults were not that likely. 2. After the mid 1990s, while the GSEs’ mortgage underwriting standards deteriorated and their mortgages became much riskier, there was no housing downturn, and there was only one mild recession in 2001. In fact, from July 1995 to May 2006, the bellwether housing index of Case and Shiller increased by 196%, with no months experiencing a decline. Many analysts and politicians didn’t think that credit risk was an issue by 32 mistakenly not taking into account the fact that homeowners don’t default (i.e., if necessary, they sell) if their underlying house collateral has appreciated in value. Point 2 above is important. Common wisdom is that Fannie Mae and Freddie Mac blew up because of their risky behavior with respect to 2006 and 2007 mortgage vintages, which consisted in a significant measure of high-risk mortgages. The 2009 credit reports of Fannie show, for instance, that in 2007, it had as much as 25% of its loans with LTV above 80% and 18% with FICO score below 660, and in 2006, had as much as 22.5% in sub-prime and similarly 18% with FICO score below 660, and in 2006, had as much as 22....
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For the next three years Fannie and Freddie’s risky...

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