FHFA Report

August 27, 2010

FHFA Report

FHFA, Fannie and Freddie's Conservator, yesterday released a report on the two companies that validates what many of us have been saying since mid-2008 when they melted down.

The report concludes that their failure was driven by losses in their credit guarantee book, and "Nontraditional and higher-risk mortgages concentrated in the 2006 and 2007 vintages account for a disproportionate share of credit losses." Moreover, "house price declines and prolonged economic weakness have taken a toll on the credit performance of traditional mortgages." Fully 73 percent of their capital loss was attributable to the credit guarantee business.

Since 2008, the credit quality of Fannie and Freddie's book has improved considerably, the report notes, as the new books feature "...on average, higher credit scores and lower loan-to-value ratios and include few higher-risk products."

Private label securities issuers, the report finds, were the drivers of high risk, nontraditional loans in subprime and Alt-A.  Their dominance of the market 2004-2007, and the "originate to sell" model that fed their securitization machines with increasingly toxic and unstable mortgages pushed Fannie and Freddie's market share to historically low levels.  

The report documents the sharp decline of Fannie/Freddie market share from a high of 70 percent in 2003 to 40 percent in 2006.  This loss of share and the fear of becoming "irrelevant" and missing the gravy train that was feeding Wall Street drove the companies out of their traditional comfort zone and into trying to find a role in lending with dangerous features, like interest only and low Alt-A documentation standards.  

The report also notes that crash in home prices and prolonged economic weakness also has stressed their conventional, monoline asset base.

The investment portfolio, long GSE critics' cherished whipping boy as the purported source of their systemic risk, contributed only 9 percent of their capital erosion from 2007-2010, primarily from write offs and impairments of Alt-A and subprime bonds acquired during the boom.  Freddie seems to have suffered significantly more from such losses than Fannie, with other than temporary impairments of $28 billion vs. $17 billion, respectively, according to the report.

The report documents very poor performance of loans with credit scores below 620 and downpayments less than 10 percent.  Their serious delinquency rates ranged from 8.6 percent in 4Q07 to 28 percent in 4Q09 in Fannie's book, with Freddie showing lower but still high delinquencies.  But these loans made up only 1.2 percent of Fannie's credit book in 2Q08, and 6 percent of the losses in that period.  Alt-A, by contrast, was 11 percent of Fannie's credit book but 47 percent of its losses in that period.

There are many lessons to be learned from the meltdown.  FHFA's straightforward analysis of the company's performance is welcome and helpful as debate heats up on the future design of the mortgage finance system.