How Sound are the Fannie Mae and Freddie Mac Recoveries?

Fannie Mae and Freddie Mac (Fannie and Freddie) are the government-sponsored enterprises that back the majority of U.S. residential mortgage loans. In the last financial crisis, Fannie and Freddie played a large role by their purchase of inadequately qualified loans, subsequent bankruptcy, and bailout by the U.S. government. As a result, much has been written about the importance of monitoring the quality of mortgage loans purchased by Fannie and Freddie.

Recently, Fannie and Freddie have made new headlines due to its turnaround under government control. With the latest dividend payment, Fannie and Freddie have paid a total of $266 billion to the U.S. Treasury, making the bailout a tremendous success. In this article, the authors report our findings on the changes in Fannie and Freddie’s mortgage loan quality by analyzing over 15 million loans originated by Fannie and Freddie during the period of 2001-2015. Our results indicate an increase in the quality of post-crisis loans compared to pre-crisis loans, especially in debt-to-income ratio (DTI) and credit score (FICO) requirements. However, we also find that since 2008, their loan-to-value (LTV) requirements have been loosened, which has resulted in a steady increase of first-timer home-buyer loans.

The average characteristics of first-time home buyers are: higher LTV, lower FICO scores, and more likely to carry private mortgage insurance (PMI). As such, in the event of another downturn in the housing market, these loans are more susceptible to default. Accordingly, despite Fannie and Freddie’s recent positive performances, this article highlights the importance of monitoring the percentage of first-time homebuyer loans as well as LTV ratios within Fannie and Freddie’s mortgage portfolios.

Credit Supply of the Housing Market

The authors examined the credit supply of the housing market, which as of 2017 appears to have recovered from the 2008 financial crisis (see Case-Shiller Home Price Index in Figure 1). However, our question was whether the recovery was as complete as the Case-Shiller Home Price Index would appear to indicate, or whether there were still areas of vulnerability that would leave room for history to repeat itself.

Figure 1:

Case-Shiller 20-City Composite Home Price Index

Source: S&P Dow Jones Indices LLC

The majority of U.S. residential loans are sold in the secondary market where they are securitized, i.e., packaged into mortgage-backed securities and sold to investors. The two biggest securitizers are the government-sponsored enterprises Fannie Mae and Freddie Mac. As of 2010, 67 percent of residential mortgages were securitized, and 54 percent were securitized by Fannie and Freddie.[1] Fannie and Freddie were partially blamed for the 2008 crisis because, in alignment with the U.S. government’s first-time home ownership initiatives, Fannie and Freddie lent to less qualified borrowers. Hendershott, Hendershott and Shilling have provided a detailed summary of Fannie and Freddie’s role and influence in the housing market credit bubble.[2]

As the housing market has recovered, there have been stories about Fannie and Freddie’s tightening of their lending criteria.[3] But we wanted to know: how specifically have they changed their lending criteria after the financial crisis? Have loan qualifications indeed been made more stringent, and if so, in what ways?

The authors investigated these purportedly higher qualifications by looking at three major lending criteria: loan-to-value (LTV) ratio, debt-to-income (DTI) ratio, and credit score (FICO). These criteria are used to measure what have been considered the two driving factors behind a borrower’s choice to default, which are ability to pay and willingness to pay.

  • DTI and FICO score relate to the borrower’s ability to pay the payment on time. A considerable amount of research finds that a high DTI and a lower FICO score result in a higher probability of default (for example see references[4], [5]).
  • LTV measures the borrower’s willingness to pay. Where the house value falls below the loan balance, borrowers are likely to strategically default on mortgage payments, even if they are able to Even where house prices increase and the current LTV does not exactly reflect the initial LTV at the time of origination, empirical research shows that the initial LTV nonetheless has predictive power in default determination.[6]

The authors also examined how loan qualities were different for first-time home buyers (FTHB) compared to non-FTHBs. Historically, more than a quarter of all borrowers have been first-time home buyers. Research is inconclusive as to whether these FTHBs tend to default more.[7] However, statistically, FTHBs are likely to be younger households with less established financial resources. As a result, it may be argued that they have a higher risk of default (although this risk might be partially mitigated by the fact that they may also have greater ability for quicker re-employment).

Data & Analysis

Quality of Fannie Mae and Freddie Mac Loans

Fannie and Freddie have released loan-level origination and performance data from 2000 (Freddie Mac data is available from 1999; Fannie Mae data is available from 2000). Our study covered a total of 15 million loans, all of which are 30-year fixed rate purchase loans for primary residences. Figure 2 displays the total number of loan originations (left axis). The blue bars represent the number of FTHB loans, and the red bars are non-FTHB loans. The gray line on the right axis represents the FTHB ratio amongst the total number of loans. Figure 2 displays, as commonly known, the sharp decrease of loan originations following the financial crisis of 2008 until 2012. It also displays that as of 2015, loan origination activities have recovered to pre-crisis levels.

Notably, since 2006, more FTHBs have entered the housing market. The historical average of FTHBs is about 25 percent of total home buyers; in 2015, FTHBs were about 45 percent of the total number, which is a significant increase. Considering this noticeable change in the FTHB ratio, we investigated FTHBs separately in the subsequent loan quality analyses.

Figure 2:

Loan Originations

As a first step in our investigation, we examined the two ability to pay measures. Figure 3 shows the historical average DTI. The gray, blue and red lines indicate all FTHB and non-FTHB loans, respectively. From 2003, Fannie and Freddie allowed higher debt payment relative to income, which increased the risk level of a loan. By 2008, the year of the crisis, the average DTI was 39 percent. Following the market crash, Fannie and Freddie tightened the DTI to approximately 35 percent. However, more recent figures show that DTI is on the rise. Additionally, FTHBs appear to have lower DTI than non-FTHBs by approximately 2 percent. This gap is offset by the fact that FTHBs usually take out loans higher than 80 percent LTV, which then require private mortgage insurance (PMI), leading to additional monthly payments. For example, in 2015, more than 62 percent of FTHBs obtained loans with PMI. Annual PMI premiums range from 0.3 percent to 1.5 percent of the original loan amount.[8] Applying even a conservative premium of only 0.41 percent of annual PMI fee to the FTHB average loan size of $226,000, the resulting PMI premium would be $927 per year. Consequently, an average FTHB with an annual income of $41,000, would need to pay more than 2.3 percent of their income for the PMI; this would in turn offset the reported 2 percent lower DTI level. Thus, there would be almost no difference in DTI between FTHBs and non-FTHBs.

Figure 3:

Debt to Income (DTI)

Fannie and Freddie also significantly raised FICO standards. Before the financial crisis, the average FICO score of loan applicants was around 730. Currently, it hovers around 760. However, as Figure 4 shows, this standard appears to be dipping. Furthermore, FICO scores for FTHBs are more than 10 points lower than non-FTHBs.

Figure 4:

Credit Score (FICO)

Next, the authors looked at the willingness to pay measure, and Figure 5 shows the average LTV level. The LTV limit was at relatively low levels until 2011. Current LTV levels, however, are even higher than at the pre-crisis level. In 2015, the LTV level of FTHBs was 86 percent, which was 6 percent higher than non-FTHBs at 81 percent. This higher initial LTV level exposes FTHBs to the default incentives when house prices drop.

Figure 5:

Loan to Value (LTV)

If LTV is greater than 80 percent, lenders typically require PMI. This insurance premium as an additional expense reduces the borrower’s ability to pay. As FTHBs have higher LTV rates, more FTHBs have PMI payments. Figure 6 shows the ratio of loans that also had PMI. In 2015, almost 62 percent of FTHBs were paying for PMI, whereas only 45 percent of non-FTHBs had PMI. Thus, even if FTHBs had lower DTIs, this PMI added an extra payment obligation.

Figure 6:

Loans with Private Mortgage Insurance (PMI)

First Time Home Buyers (FTHB)

In this next section, the authors further investigated characteristics of FTHBs. Figure 7 shows borrowers’ average incomes, based on DTIs, loan sizes, interest rates and loan terms. FTHBs have lower average income than non-FTHBs: in 2015, these figures were $41,000 versus $44,000, respectively.

Figure 7:

Income

The relatively lower income of FTHBs indicated by the blue line in Figure 7 corresponds to the fact that FTHBs purchased lower-priced houses. Figure 8 displays the prices of these houses. As expected, because FTHBs were likely to be younger with less accumulated wealth and income, their purchase price level was lower than that of non-FTHBs. And, in 2015, the average house price of FTHBs was $260,000 while for non-FTHBs it was $310,000.

Figure 8:

House Price

House prices develop in different patterns depending on price tiers. See, for example, the Los Angeles Case-Shiller indexes for low-, middle- and high-tier price indexes in Figure 9. Low-tier prices are more volatile than the middle or high tier prices. Since FTHBs tend to buy lower price houses, FTHBs are more likely to go through unstable price changes in the future.

Figure 9:

Case-Shiller Index by Price Tier: Los Angeles

Source: S&P Dow Jones Indices LLC

Findings thus far suggest FTHBs represent a higher risk (higher LTV, lower FICO, and lower-tier housing market). This riskiness should be priced into their interest rates. Figure 10 displays the average interest rates of FTHBs and non-FTHBs. FTHBs were charged 0.05 percent higher interest rate on average, which merits further research as to whether this spread is sufficient to incorporate all risks associated with FTHBs.

Figure 10:

Interest Rate

 

Conclusion

Our investigations into Fanny and Freddie’s loans from 2001 to 2015 show that they did tighten standards for loan qualification after the financial crisis, as measured by higher average DTI and FICO scores. However, we also found that they did not tighten LTV requirements; in fact, LTV ratios have been rising since 2008. Furthermore, in the last few years, Fannie and Freddie have once again lowered their lending standards, likely due to criticisms that they have been too tight.[9] Thus, there is a growing risk attendant to the lowering of LTV standards, as it leaves Fannie and Freddie vulnerable for another housing market downturn.

The authors also found an increased percentage of first time home buyers (FTHBs). The characteristics of FTHBs are, generally, that they tend to borrow to their maximum capacity with a higher LTV, which requires extra PMI payments. Also, FTHBs tend to have lower FICO scores than non-FTHBs. Lastly, FTHBs tend to be in the low-tier housing market, which is more volatile than the middle or high-tier markets. Though on average FTHB loans have slightly higher interest rate (0.05 percent) than the non-FTHB loans, it is questionable whether this rate difference is sufficient to compensate for the higher risk associated with these borrowers.

Overall, despite recent positive performances by Fannie and Freddie, our study also revealed the growing need for increased monitoring of their deteriorating LTV standards and historically high number of FTHB loans. We also highlighted the need for further research as to whether the interest rate differential of 0.05 percent for FTHBs compared to non-FTHBs were sufficient to incorporate all risks associated with FTHBs.

 

[1] The Financial Crisis Inquiry Commission. (2011). “The Financial Crisis Inquiry Report”. January: p.69.

[2] Hendershott, P., Hendershott, R., & Shilling, J. (2010). The Mortgage Finance Bubble: Causes and Corrections. Journal of Housing Research 19: 1-16.

[3] MarketWatch. (2017). “Mortgage lending is so tight, more people aren’t even bothering to apply.” February. Accessed at http://www.marketwatch.com/story/mortgage-lending-is-so-tight-more-people-arent-even-bothering-to-apply-2017-02-14

[4] Holden, S., Kelly, A., McManus, D., Scharlemann, T., Singer, R., & Worth, J. D. (2012). The HAMP NPV Model: Development and Early Performance. Real Estate Economics, 40, S32-S64.

[5] Rose, M. J. (2012). Origination Channel, Prepayment Penalties and Default. Real Estate Economics, 40, 663-708.

[6] Deng, Y., Quigley, J. M., & Van Order, R. (2000). Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options. Econometrica, 68, 275–307.

[7] Ambrose, B. W., & Capone, C. A. (1998). Modeling the Conditional Probability of Foreclosure in the Context of Single-Family Mortgage Default Resolutions. Real Estate Economics, 26, 391-429.

[8] Lewis, H. (n.d.). “Private mortgage insurance, or PMI: Just the basics.” Accessed at http://www.bankrate.com/finance/mortgages/the-basics-of-private-mortgage-insurance-pmi.aspx

[9] MarketWatch, 2017.

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What’s Next LA: The Road to Economic Recovery

Beacon Economics, the Graziadio School of Business and Management at Pepperdine University, and the Los Angeles Area Chamber of Commerce have joined forces to launch a new, annual Los Angeles Economic Forecast Conference.

In this video interview, Dave Smith, PhD, Associate Dean of the Graziadio School and Chris Thornberg, PhD, GBR Editorial Review Board Member and principal of Beacon Economics, offer a preview of what they will be discussing at the conference.

Join us at the inaugural event on Tuesday, July 28 as we provide a thought-provoking look at where the national, state, and Los Angeles economies are headed. Featured speakers include Linda A. Livingstone, PhD, Dean of the Graziadio School of Business and Management, Brad Kemp, Director of Regional Studies for Beacon Economics, and John Paglia, PhD, Associate Professor of Finance at the Graziadio School.

Visit beaconecon.com to register or for more information.

Questions for Christopher Thornberg

  1. Why is California different from the rest of the nation in this recession?
  2. Where do you see inflation and interest rates going in the next year?
  3. What about the banking sector? What do you see happening in both the short and long term?
  4. Both home sales and mortgage delinquencies are rising. Which matter more to the housing market recovery?
  5. How do you see the state and city budget shaping up in the next year?
  6. How does Los Angeles fit into the recovery in the state? Which industries will lead the way out of this downturn?
  7. What should viewers know about the economy today and where we’ll be a few years from now?

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The Foreclosures.Com Guide by Alexis McGee

The Foreclosures.Com Guide to Making Huge Profits Investing in Preforeclosures without Selling Your Soul

By Alexis McGee
Wiley, 2007

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Can you really make huge profits investing in foreclosure real estate?

People have surely done so in the past.

Is doing so as easy as “everyone” would have you believe?

Probably not.

Can just anyone do it?

Clearly not.

And now, the most important question: Can this book help you make huge profits by investing in pre-foreclosure real estate?

Again, probably not. But reading The Foreclosures.com Guide will give you a lot of information, as well as some interesting investing stories, which will stimulate your thinking about how to make a lot of money.

What this book is: Essentially, this book provides a framework for offering counseling to those whose houses are in or are near foreclosure-that is, the process by which a lender sells a house to settle the outstanding liens against it.

According to the author, that counseling may lead to a profit, but may also simply lead to “feeling good” about what you might do to help another human being who is in trouble.

The book contains many anecdotes-stories of successful and unsuccessful investors who worked to invest in foreclosures. The stories are amusing, but are clearly fluff meant to entertain.

The real strength of the book for the beginning investor is its review of the laws surrounding foreclosure (including the book’s caution that laws vary by jurisdiction, and its injunction that you make sure you are following the laws of the jurisdiction in which you are helping); its general background on the terminology and landscape of foreclosure; and an excellent glossary of terms.

The Foreclosures.com Guide also offers a rudimentary education in the finance and mathematics of investing in foreclosures, as well as sources of additional information, including McGee’s website, Foreclosures.com.

What this book is not: Although the book provides a primer on foreclosure, I caution readers: Do not invest your first million after simply reading this book.

For many of us, real estate has been the best long term investment we have ever made. Many investors believe that housing prices will decline and that marketing times for houses will increase in the intermediate future. However, the current headlines are replete with bad news for real estate investors. As an investor, you need to examine the real estate climate for yourself to determine whether the timing is right for you.

Consider taking a class in real estate finance and attending a few real estate auctions to get a flavor for what goes on in a foreclosure. Experience is a teacher. It is important that that education not be too expensive.

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