12 22 risky business while the hud report was

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12 2.2 Risky Business While the HUD report was describing these changes in Fannie and Freddie’s underwriting as a success, the report is confirmation of the impact of FHEFSSA. Examples of such underwriting practices include Fannie Mae’s introduction of their Flex 97 product, which required a borrower to make only a 3% downpayment if the borrower has a strong credit history.
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29 As the mortgage-backed securities (MBS) market took off in the 1980s, Fannie and Freddie dominated the growth in this market as a result of their government support. The credit-risk profile of Fannie and Freddie’s mortgages in those days, however, was reasonably safe: (i) low- to medium-sized loans, (ii) loan-to-value ratios less than 80%, (iii) high standards for a borrower’s creditworthiness, and (iv) income documentation of the borrower’s ability to make interest payments on the loans. This does not mean that Fannie and Freddie were not without risk. But many analysts and economists at the time considered the greater source of risk to be the interest rate risk of Fannie and Freddie’s mortgage portfolio, not the credit risk of their portfolio plus their outstanding MBS. But something dramatically changed with FHEFSSA. While the 1992 Act required Fannie and Freddie to hold only conforming mortgages, there was considerable wiggle room. A conforming mortgage had to be less than a certain dollar amount (the “conforming loan limit”), have a loan-to-value (LTV) ratio less than 80% (or, with wiggle space, a higher LTV with private mortgage insurance), and meet unspecified “investment quality standards”. Not surprisingly, the above housing goals combined with the ambiguity of what constitutes a conforming mortgage translated into considerably riskier credit portfolios. As an illustration of this, consider data on Fannie Mae’s year-by-year mortgage purchases over the next decade from 1992 onwards. While complete data are not available, using the annual reports of Fannie and Freddie, and recently released data by the FHFA, Figure 2.1 graphs the share of risky mortgage loans each year, as defined by either LTV>90% or 80%<LTV<90%. 13 While it was commonly known that the FHA and VA made risky loans, it is less well-known that Fannie (and Freddie) already had a growing presence in the high LTV mortgage market during the 1990s. Fannie’s role generally increased over the next several years both in dollar amounts and market share. For example, from just 6% ($11.6 billion) of loans having LTVs>90% in 1992, by 1995, the number of loans with LTVs>90% had doubled to $20.9 billion and 19% of Fannie Mae’s purchases. Though the percentage of loans with LTVs>90% dropped to 13% by 2001, the dollar amounts increased substantially to $68.3 billion. While Freddie Mac’s annual reports provide only a snapshot of their mortgage holdings by year, the data tell a similar story. For example, in 1992, their mortgage book held just 3% of its loans with original LTVs>90% (and 13% with 80%<LTV<90%). The next year, this number
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30 increased to 4% and 15% respectively, and by 1994 to 9% and 18%. By the late 90s, the number had steadied to around 10% of loans with LTVs>90% and 15% with 80%<LTV<90%.
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