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Monday, July 21, 2008

Adverse Markets: Fannie/Freddie's Vicious Redlining

Last week, I pointed out that I feel as though the problem with both Fannie Mae and Freddie Mac is that they act much like socialistic monopolies. Now, many times people read a piece like that and they don't necessarily see how it affects them. Many people might bemoan the fact that these two are structured poorly but they won't make the connection to their own lives. In fact, their poor structure affects everyone's life all the time, and the latest installment is a new rule each has installed called adverse markets.

Adverse markets involve all sorts of new restrictions and guidelines for loans in areas especially hard hit dropping real estate values. This includes new fee restrictions, new loan to value restrictions, and new rules for appraisals. While adverse market areas are those that are especially hard hit by falling real estate values, the determination is made entirely by Fannie Mae and Freddie Mac. In other words, what is an especially large drop in real estate price is entirely in the eyes of those two.

The most worrisome new rules in adverse markets have to do with new guidelines for appraisals. What Fannie Mae and Freddie Mac want is extra comparisons in these markets. First, here is a quick lesson in how real estate value is determined. Real estate value is determined by comparing the subject property to other properties as close in style, square footage, number of rooms, etc. that sold in the area and within a relatively short time frame. (in other words a thre bedroom home 2500 square feet should be compared to other homes as close to those dimensions as possible) The industry standard is within six months and within one mile. Generally, a bank wants three comparisons to determine value. Of course, often times these rules are only a guide. After all, depending on the property, it may simply be impossible to find three comparisions within a mile within six months.

What happens in adverse markets is that no longer is this merely a guide, but now it is a hard and fast rule. Furthermore, Fannie and Freddie want extra comparisons. Now, in adverse markets, they want a minimum of five comparisons. Of course, this is totally counter intuitive. In adverse markets, properties have simply not sold. That's why prices have fallen. Now, rather than loosening their restrictions, Fannie and Freddie make it even more difficult to get a loan done in those areas. What this will do is drop prices even further.

Furthermore, on certain property types it will simply make it impossible to do the loan. Imagine if a borrower is trying to purchase a four unit property in an adverse market. It is likely that there are simply nowhere near five comparisons up to the specifications of Fannie and Freddie. If one four unit can't be sold that makes all other four units that much more difficult to sell. If a property is in an adverse market already and Fannie and Freddie make it virtually impossible to sell, then that creates a vicious cycle. Of course, Fannie Mae and Freddie Mac aren't the only way to get a loan, but they are darn near close. Certain properties can be sold outside of Fannie and Freddie but more times than not this will make properties in those areas nearly unsellable. In other words, in one fell swoop, Fannie and Freddie have just crushed the real estate market for multi units in adverse markets. Since these properties will be virtually impossible to do a loan for, the prices for these will continue to drop until Fannie and Freddie change their rules.

Redlining, at least in mortgages, is the practice by banks of restricting mortgages in certain areas. Well, that's exactly what Fannie and Freddie have done with their new rules in adverse markets. By creating new rules that make appraisals more difficult in adverse markets, they will accomplish covert red lining. They will simply create rules that make certain properties impossible to do a loan for with Fannie Mae and Freddie Mac. Furthermore, since both control the overwhelming majority of the market, this redlining becomes institutional. Fannie and Freddie have now made it so that many properties are simply impossible to finance. If a single bank did this, civil rights activists would be screaming bloody murder. Yet, we know have the securitizers doing it, and no one even notices, unless you are trying to finance the loan that is.

Of course, this is happening strictly because they maintain a monopoly on the market for mortgage securitization. If there was more competition, and one of them tried this, one of their competitors would open up the market for such loans. It is unclear what Fannie and Freddie's intention was with the new adverse market rules, but the effect is to make many multi units simply impossible to do in those areas. If a bank ever did what Fannie and Freddie did, they would be brought up on charges. Yet, Fannie and Freddie are not only doing it but making covert redlining one of their rules.


Anonymous said...

As recently as 10 years ago it required a 30% down payment to purchase your hypothetical 4-plex--which I did. I recently talked to my banker about purchasing another multi-family residential rental property. Guess what--30% down and good credit will still get you a loan at great interest rates even in an "adverse market."

What is called "adverse" today used to be called business as usual. Suck it up boys and girls and put your money where your investment is. Banks want you as a partner not a charity. Remember risk=reward? Frankly I'd prefer to get the rewards rather than my banker.

mike volpe said...

That's a non sequitor. For many of the unusual properties in adverse markets, fannie and Freddie won't lend at all. Period. Thus, it will now require 100% down payment. Yes, the down payment requirements have been loosened, however the requirement for doing the appraisal have been done so that it is impossible for some properties to be approved at all with fannie.