Jackson Jambalaya

Fannie Mae recently disclosed that it was suffering from huge losses due to the turmoil in the mortgage markets: "WASHINGTON (Reuters) - Fannie Mae , the largest U.S. mortgage finance company, said on Friday its third-quarter net loss doubled from last year as slumping home prices and a credit squeeze drove down values of mortgage securities. "

Most experts opine that the current crisis in the mortgage markets was due to the turmoil involving subprime and "Alt-A" mortgages as well as a decline in home prices nationwide. Numerous lenders have gone out of business, layoffs in the industry are widespread, and borrowers have found that it is now much tougher to get a mortgage than a year ago as they are required to have higher credit scores and more money for down payments. The specter of subprime ARM readjustments has reared its ugly head as the latest bugaboo to spook Washington and Wall Street. Unfortunately, this may not be the worst of it as there is still another ticking time bomb that has nothing to do with ARM resets or a falling housing market.

Fannie Mae and Freddie Mac made the decision several years ago to lower the requirements approving a mortgage application. Fannie and Freddie mortgages (called conforming) are desirable as they have the lowest rates as compared to mortgages not backed by Fannie and Freddie (called nonconforming. At this point, Fannie and Freddie will be called the agencies.) In the past, a borrower had to put down 3-5% of the purchase price for a down payment, have a minimum credit score of 620, have a debt to income ratio (that is where monthly bills on the credit report, utilities are NOT included, are divided by the gross monthly income) of 36% as well as meeting other requirements.

However, the agencies decided to offer mortgages to borrowers who could not meet those requirements. These mortgages were called expanded approval loans. Credit score requirements were lowered. The agencies started taking credit scores in the 500's. Indeed, if a borrower had enough money to put down on a house (such as 50%), then very bad credit was overlooked. The criteria became more flexible. The minimum credit score was lowered if the borrower had more assets, had a low debt to income ratio, and the loan to value (value of the home) was lower. The agencies offered "flex 100" loans where the borrower did not have to put any money down. The borrower was still required to purchase mortgage insurance, which could be quite high depending on the credit score. The agencies then lowered the credit score requirements. It was not uncommon to see borrowers with credit scores of 590, 600, or lower approved by the agencies for mortgages with no money down. Keep in mind these mortgages are NOT ARMs but are fixed rate mortgages. However, the agencies DID raise the rates on these loans by grading them at certain levels: Expanded Approval I, II, III. Each level had a higher rate. One that was a III usually had a rate that was at least 1.5% above the regular conforming rates so the agencies did try to offset the higher risk with higher rates.

However, the aggressive lending did not stop there as the agencies rolled out their community lending programs in 2003. These weakened the requirements even further. Under the Flex 100's, the borrower still had to have 3% of his own funds for closing costs. Under the community lending standards, that requirement was abolished and replaced with a $500 minimum down payment requirement (It could be a gift from a family member). The mortgage insurance coverage rate was cut from the 35% required for a flex 100 to 20% for a community lending program. The rate was only slightly higher than a regular conforming loan, usually a quarter to a half of a point. The agencies approved these loans for borrowers that had credit scores as low as 570 and in rare instances, even lower. Debt to income ratio requirements were eased as the 100% loan to value mortgages were approved borrowers having ratios of 55%! (remember, that ratio is based off of gross income, not net income after taxes). No one wanted to ruin the party as these new programs became very popular among realtors, lenders, and mortgage companies.

However, this may be a ticking time bomb waiting to explode in the agencies' portfolios as defaults climb. One must ask if the agencies are losing money merely because of falling housing prices and lower levels of business or because of these loans that were approved under much easier underwriting standards. The mortgage insurance companies have quit (or soon plan to do so) insuring mortgages that have a credit score under 620 if the loan to value is more than 95%. This is to be expected as they have suffered huge losses in 2007 and it also tells you where the defaults may be coming from as most of these so-called experts have not realized most subprime mortgages DO NOT require mortgage insurance. Fannie Mae just announced that it is implementing a pricing increase for mortgages that have a credit score below 680 and a loan to value above 95% that will add approximately .500-.750 to the conforming rate. The agencies have also tightened their underwriting requirements (this contributing more to the housing slump) so that borrowers with lower credit scores with

Even with these price increases by the agencies and stricter underwriting guidelines, one must still wonder if they are closing the barn door after the horse has already left as the expanded approval and community lending mortgages sit on their books. If that bomb explodes, it will make the subprime explosion look like a firecracker.