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Saturday, November 15, 2008

The Tyranny of Duopoly: Fannie/Freddie's New Pricing Policies

When Fannie/Freddie asked for a bailout in July, these two giants, who before mostly stayed in the background, burst onto the national scene. With it, there came a national debate over their roles in just about everything. Many so called "experts" even try and pin the blame them for the crisis itself. While there is a lot of debate about their role, there is little debate about how to structurally change these two giants so that they never poison the market again. When they burst on the scene in need of roughly $50 billion in order to function, the whole country took notice. Unfortunately, the tyranny thest two perform everyday inside the mortgage industry gets little notice. It is a tyranny they are afforded because Fannie Mae and Freddie Mac maintain a Duopoly in Mortgage Securitization. By maintaining this Duopoly, they, together, make each and every rule. Because the securitizer is the ultimate holder of any given loan, it also means that setting rules applies to every part of the process: pricing, underwriting, and the terms.

Throughout the boom, Fannie/Freddie loans were essentially pass fail. What this means was that either a particular loan did or didn't qualify. Both Fannie/Freddie also had a sort of minor league of loans, known as Expanded Level, for borrowers that didn't qualify for their best product. That said, neither Fannie/Freddie made a distinction in terms of pricing for a borrower with a 650 credit score or a borrower with an 800 credit score. If both borrowers qualified, they got the exact same rate. Both made distinctions for property types. In other words, a two unit property received a slightly worse rate than a single family home. Of course, they also made distinctions for property dispositions. In other words, there was a rate difference for an investment property over a property the borrower would occupy. Finally, each made a small distinction for loans with very high loan to value. A loan which put only 5% down (or had only 5% in equity in the case of refinance) received a slightly higher rate than those with 10% down and more. In this case, the rate was only about an eighth of a percent worse.

As such, up until this year, most folks got the exact same rate as long as they qualified. This all changed at the beginning of the year. Now, each have all sorts of new break points. A borrower with a 650 credit score receives a significantly worse credit score than one with a 750 score. In fact, anyone with less than 740 credit score now receives a pricing adjustment. A 740 credit score is found in top one half of one percent of all borrowers. What's more, while there is a pricing adjustment for the credit score, there is no adjustment for other factors that one could consider important. For instance, someone with a 650 score gets a worse rate than someone with a 750 score. Someone that shows that they have $100,000 in the bank though, gets the same EXACT rate as someone with nothing in the bank, assuming both qualify. Someone with a debt to equity ratio of 15% gets the same rate as someone with a 45% debt to income ratio.

Beyond this, the two have also made adjustments at much lower loan to values. For instance, there is almost no adjustments for loans below 70% loan to value regardless of the credit score. Over 70% though, things begin to adjust and the adjustments become more acute when higher loan to values are combined with lower credit scores. For instance there is a massive adjustment for someone with an 80% loan to value and a 650 credit score.

This change, less than a year old, is a near 180 degree turnaround in the way that each do business. It is certainly open to debate whether or not this is a good idea. Some might even say their adjustments don't go far enough and weren't done soon enough. What can't be argued is that each made the EXACT SAME rule changes at the exact same time. Furthermore, Fannie/Freddie loans are about 85% of all residential loans currently. In other words, by dictatorial fiat, the two have revolutionized the way in which mortgages are priced, and by extension the rates that borrowers get, overnight, without warning, and without anything anyone else can do about it.

They can do this because there are two of them controlling this mysterious market known as mortgage securitization. Mortgage securitization is the process in which loans are packaged togehter and turned into bonds. It is vital in maintaining liquidity because it allows banks to immediately unload a loan and have more money for the next loan. Now, it is like a drug. Because banks are now trained only to do loans that are eventually sold to Fannie/Freddie they couldn't do it any other way even if they wanted to. Even during the boom, those loans that banks did on their own and held in their own portfolio made up no more than 10% of the market. Now, it is no more one percent.

Whether you agree with the changes made by Fannie/Freddie in pricing, one thing is clear. They couldn't have made such revolutionary changes if the market for loan securitization was an actual market. If there was more than two of them, they wouldn't be able to suddenly become so restrictive in price and get away with it. One of their competitors would take advantage of the draconian rule changes and offer an alternative and banks would have their loans securitized through them.

Fannie/Freddie have two problems, they are quasi Socialisitic and they are monopolies. The problems of their quasi Socialism reared its ugly head when they were bailed out. The problems of their monopolization rears its ugly head in their tyrannical rules like the one I just illustrated. Fix both problems and you fix the giants.

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