Kersnar's Corner

Are Fannie And Freddie To Blame?

By Scott Kersnar, Senior Editor, Mortgage Technology Magazine

You may think it's about time to stop all this obsessive blame placing over the subprime collapse. Not so fast. For one thing, there's the funny Billy Joel-inspired Wall Street meltdown song on YouTube to keep our nerves on edge. For another we have walking-wounded former industry players stepping forward to debrief on lessons sadly learned.

"Who knows what the next chapter will reveal," muses Ed Jones now that his ARC Systems has closed its doors. "Maybe we should do an article on credit cards, how they are being manipulated and promise to be the next debacle equivalent to what's happened in subprime - not exactly mortgage, but it will be just a devastating. With loan restrictions being tightened it will be more and more difficult for people to get home-equity loans to pay off their credit cards."

From a market failure "that allowed a 3 percentage point jump in serious delinquency rates on a subsection of U.S. mortgages to throw a $57 trillion U.S. financial system into turmoil," as an IMF commentary put it, we're hearing from all but the good-news junkies that the credit squeeze is radiating out in all directions. Mark Dangelo, managing principal of the consulting firm Innovative Relevance, is among those who say Wall Street was more to blame for the subprime collapse than was the mortgage industry itself. "And as you look at the fact that Wall Street was securitizing roughly two-thirds of this stuff, you have to ask, 'Where were the rating agencies?'"

But why keep harping on the blame? The point now is to contain and clean up the mess, isn't it? No, Contour Software founder and M&A consultant Scott Cooley insists, "People need to know the very important role that the GSEs played in our current debacle. Not that they take all the blame, but they aren't being recognized for the huge role they did play."

Since 2005, Mr. Cooley has been saying that a big factor in sustaining a bubble in risky sectors of the real estate finance market was that the GSEs "lowered their standards through the AUS during the housing boom without regard to their long-term impact and without knowing the high risks of doing such."

He argues that "as each year went by that there was no substantial increase in foreclosures, they lowered their standards again." Nevertheless, Wall Street and the mortgage industry both continued to think of Desktop Underwriter and Loan Prospector as bulwarks against undue credit risk - rather than as engines of competition for subprime loans. When Fannie and Freddie entered the subprime arena, he said, they pushed subprime lenders "into the tranches of unacceptable quality. Subprime lenders had no choice but to accept the unacceptable. Further, since the GSEs accepted much lower quality loans as still being agency loans, the credit agencies and Wall Street were duped into believing that the GSEs' ability to determine a conforming loan vs. a subprime loan as gospel."

Thus, in Mr. Cooley's view, because the black box GSE AUS provided no transparency, the changes they made in their algorithms to include subprime product didn't just offer better ways to referee the mortgage game, they changed the size and shape of the playing field without telling the other players.

Rather than blaming the rating agencies for not taking better note of subprime risk, he said, "I believe the rating agencies at least implicitly relied on the GSEs in their ratings assigned to mortgage pools. The definition of a prime loan for the last 40 years was a loan purchased by the GSEs. Clearly, the GSEs have been buying subprime loans this decade and are just recently adjusting their AUS to stop doing so. These changes to underwriting rules served to exaggerate this housing boom/bust cycle whereas in decades back the GSEs' consistent underwriting rules served as a calming factor in the cycles. Clearly, if the GSE old school underwriting guidelines were still being used, this boom/bust cycle would not have been nearly as severe."

Mr. Dangelo points out that while the GSEs may not be blameless, their charters compel them to extend the opportunities for homeownership to underserved markets and to find ways to reduce the cost of originating a mortgage. Better, faster, cheaper, right? Evidence of how those charter obligations work is that Senate Banking Committee chairman Chris Dodd recently advocated that Fannie and Freddie use a 30% capital surplus to buy subprime loans and restructure the loans to prevent foreclosures. And now that the nonconforming market has dried up, California is leading the charge on an effort to have Congress raise the conforming limit for loans in high-cost communities so that Fannie and Freddie can be de facto jumbo investors. In Mr. Cooley's view, this amounts to Congress "letting the fox guard the jumbo market."

For a long time commentators like Allen Fishbein have joined Scott Cooley and others in advocating greater HUD oversight of GSE black box AUS to make sure, for one thing, they are not used like commercial systems that merely fast-track loan applications toward funding. Companies like New Century and MILA that boasted nearly instant decisioning are no longer with us. However, many mortgage technologists have claimed that LP and DU do not set the standard for high-performance automated underwriting systems. Can we blame Fannie and Freddie for taking up such competitive challenges and showing what they can do in the nonconforming sectors previously barred to them?

It seems to me that Fannie and Freddie are pulled in too many directions and have to respond to too many Capitol Hill and White House wish lists. They might find that offering more open access to their decisioning systems could actually anchor and depoliticize the proper role of those systems in the market. The more widely understood the function of LP and DU, the less likely that they will be the pawns of conflicting demands. In any event, we can't afford to have irresponsible use of those systems prove to us that nobody is too big to fail.