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This observation ignored two important facts 1 prior

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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
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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 high-risk mortgages and 15.2% in interest-only loans. It is certainly true that the majority of GSE losses derived from these vintages. But the losses were confined to 2006 and 2007 vintages not because of prudent lending in prior years but instead because weaker loans in earlier years were masked by the continued rising in housing prices through mid 2006. Mortgages issued in 2003 and 2004 may have been just as shoddy, but homeowners had built substantial equity in their homes by 2006 because of the large house price increases, which protected them (and Fannie and Freddie) against the subsequent price decreases. In other words, the GSEs had crossed their own Rubicon in the mid 1990s after the passage of FHEFSSA. The moment that the GSEs lowered their underwriting standards, there was no turning back, and as soon as housing prices started falling, their fate was sealed. A final observation is that the GSE Affordable Housing Goals were all stipulated as a percentage of their mortgage share. There were no growth targets. In fact, as Figure 1-1 showed their mortgage portfolios remained steady in size during 2003-2007. It was the MBS guarantee business that truly took off. The government push for affordable housing does not explain why the GSEs chose to grow the MBS guarantee business so dramatically. While their first master, HUD, might have been unhappy with a lack of growth, their second master, the GSEs’ shareholders, would have been even unhappier since investment banks had started generating substantial returns in lines of business that the GSEs could do. This is the issue that we turn to next.
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33 Chapter 3: Race to the Bottom “You’re becoming irrelevant,” Mr. Mozilo, CEO of Countrywide told Mr. Mudd, CEO of Fannie
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