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paper about MBS

It is an interesting counterfactual question to ask

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Unformatted text preview: It is an interesting counterfactual question to ask whether the GSEs’ foray into risky lending would have occurred without these mission goals. In other words, in their desire to expand, would they still have moved along the increasingly risky mortgage credit curve? We believe that, given the GSEs’ cheap source of financing and weak regulatory oversight, they would still have moved in this direction. Nevertheless, FHEFSSA made the point somewhat moot. To reach the targets, FHEFSSA called for a study of the “implications of implementing underwriting standards that (A) establish a downpayment requirement for mortgagors of 5 percent or less, (B) allow the use of cash on hand as a source for downpayments, and (C) approve borrowers who have a credit history of delinquencies if the borrower can demonstrate a satisfactory credit history for at least the 12-month period ending on the date of the application for the mortgage.” 11 A study commissioned by HUD in 2002 found that, over the previous decade, Fannie Mae and Freddie Mac had in fact adopted more flexible underwriting guidelines in terms of (A) – (C) above. 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. 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....
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It is an interesting counterfactual question to ask whether...

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