The Past, Present and Future of Fannie

Mae, Freddie Mac, and FHA

Edward Pinto
Codirector
AEI International Center on Housing Risk
Edward.Pinto@AEI.org
HousingRisk.org

May 6, 2014

The views expressed are those of the author alone and do not necessarily represent
those of the American Enterprise Institute.
1
Lessons Relearned from 2007 Housing Collapse
Mortgage loans are only as sound as the practices used to underwrite
and originate them.
Relative loan performance is largely determined by risk characteristics at origination.
Market stability depends on the preponderance of loans being low risk,
defined as good performance under stress.
This promotes mortgage debt being used to smooth housing consumption, not take on
excessive debt to support consumption in excess of income.
Martin Luther King Jr. recognized the problem of living beyond ones means in his 1968
The Drum Major Instinct sermon.
Political pressures will likely degrade sound lending practices over time.
Lack of robust risk measures limits markets ability to impose discipline.
Bottom line:
Transparent and objective measures of mortgage risk, home-price risk, and the
capital adequacy needed to evaluate and manage housing risk.
The government will blame the private sector, regardless of its own culpability.
2
A Century of Lessons
The deterioration of lending standards from the early 1990s
to 2007 has historical precedents.
Earlier episodes: 1920s, late 1950s and 1960s, early 1980s,
and late 1980s.
Mortgage default rates rose in every case, sometimes to
disastrous levels.
Prudent lending practices (or at least less risky practices)
were then re-established and defaults declined.
The pattern is clear: the abandonment of sound mortgage
underwriting standards leads to trouble.
3
















Source: Securitization in the 1920s, William Goetzmann , 2009, Securitization in the 1920's - Yale University
4
Mortgage Trouble Occurs When Mortgage
Debt Grows Faster than Home Value
Mortgage Trouble Occurs When Home
Values Grow Faster than Fundamentals

5
The Abandonment of Sound Mortgage
Underwriting Standards
Necessary pre-condition: GSE abandonment of sound underwriting
Gail Cincottas 1991 Senate Banking testimony: "Lenders will respond
to the most conservative standards unless [the GSEs] are aggressive
and convincing in their efforts to expand historically narrow
underwriting."
6
An Explicit Government Guarantee Is Not the Solution
Experience has shown that any federal insurance program
with an explicit guarantee will fail to protect taxpayers.
Assumes the government would be better at pricing risk than
the market.
Every government insurance program has failed or is insolvent.
Encourages too much of the wrong kind of debt for our
economy.
Debt that bids up existing housing assets and the land they sit on,
creating a temporary wealth effect and a crowding out of capital
investment needed for a productive and growing economy and jobs
growth.
The result will be another artificial housing boom and consequent bust.
Inevitably leads to politicized credit standards.
Will once again put lower-income families into housing they cant afford,
with the same disastrous results.
7
Most Likely Outcome: Status Quo
No imperative to pass legislation.
GSE charters are perpetual.
Loan limits set at no lower than 2007 market peak.
Treasury obligated to provide GSEs an additional $200+
billion.
No time limit on conservatorship.
Exempt from QMs 43% total DTI limit until Jan. 2021.
GSEs give the appearance of being profitable and these
profits go to Treasury.
New leadership at FHFA.
8
Given These Facts What Will AEIs New Housing Risk
Center Do to Fill the Void?
The AEI/Pinto-Oliner Risk Indices:

National Mortgage Risk Index (NMRI)
Classifies loans into low, medium, and high risk based on default
experience of 2007 vintage loans with similar characteristics.
Currently covers nearly all govt-guaranteed mortgages for home
purchases (about 75% of all purchase loans)
Limited to purchase loans now; refi loans to be added in 2014.
27-metro Composite Collateral Risk Index (CRI)
Metro areas chosen to represent housing market in U.S. as a whole.
Expected release dates: DC-area index, mid-2014; other metro areas
throughout 2014 and 2015.
Capital Adequacy Index (CAI)
Assesses capital reserves at institutions with large mortgage
exposure.
Under development. Expected release date: 2015.
9
Measuring Stressed Default Rates
Takeaway: Huge spread of default rates across risk buckets

All 320 risk buckets for home purchase loans are shown at
Periodic Table on HousingRisk.org


10
Risk Bucket FICO CLTV Total DTI Default Rate
Very Low 770 61-70% 33% 0.8%
Low 720-769 76-80% 34-38% 4.2%
Medium 690-719 81-85% 39-43% 9.3%
High 660-689 91-95% 44-50% 22.7%
Very High 620-639 > 95% > 50% 45.8%
Note: Default rates represent cumulative defaults through year-end 2012 for Freddie Macs 2007
vintage of acquired loans. The loans included in the calculation are all primary owner-occupied, 30-year
fixed-rate, fully amortizing, fully documented, home purchase loans.
NMRI for Home Purchase Loans
* Index changes measured from first month shown.
Source: AEI International Center on Housing Risk, www.HousingRisk.org. Separate index not available for VA guaranteed loans. RHS is Rural Housing Service.
Fannie/Freddie and FHA/RHS indices edged up further in March, while
composite index was little changed because of a decline in the FHA loan share.
11
4%
8%
12%
16%
20%
24%
28%
4%
8%
12%
16%
20%
24%
28%
Oct-12 Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14
Fannie/Freddie: +1.1 ppt, from 4.9% to 6.0%*
Composite: +0.9 ppt, from 10.6% to 11.5%*
Stressed default rate
FHA/RHS: +1.8 ppt, from 22.3% to 24.1%*
FHA/RHS share of purchase loans:
Jan-14: 33.0%; Feb-14: 31.5%; Mar-14: 30.3%
Calibrating Mortgage Safety
Composite index substantially above 1990 level, but not approaching 2007
level when underwriting was exceptionally lax.
Fannie/Freddie index somewhat above 1990 level and rising.
FHA index extremely high and rising. Sharp contrast with safe underwriting
during 1935-55.
12
NMRI - purchase loans Latest date
Latest
Value
1935-1955
vintages (est.)
1990 vintage
(est.)
2007 vintage
(est.)
Composite index Dec. 10.8% NA 6% 19%
Fannie and Freddie Dec. 5.8% NA 4% 13%
FHA Dec. 24.1% 3% 15% 30%

A low-risk loan has an average default rate under stress of 3% and a maximum default rate of less
than 6%. An index value of less than 6% is indicative of conditions conducive to a stable market.
GSE Low-Risk Origination Shares, Purchase Loans
Source: AEI International Center on Housing Risk, www.HousingRisk.org.
Continued downward trend in low-risk share for both Fannie and Freddie.

13
58%
60%
62%
64%
66%
68%
70%
72%
74%
58%
60%
62%
64%
66%
68%
70%
72%
74%
Oct-12 Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14
Freddie Mac
Fannie Mae
Combined
Note: FHA/RHS low-risk share (not shown) is about 1%.
Purchase Loans with Total DTI Greater Than 43%
Source: AEI International Center on Housing Risk, www.HousingRisk.org.
No discernible impact from QM regulation. Federally guaranteed loans are exempt
from Total DTI limit in QM, so share with Total DTI >43% likely to remain high.
14
10%
15%
20%
25%
30%
35%
40%
45%
50%
10%
15%
20%
25%
30%
35%
40%
45%
50%
Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14
FHA/RHS
Composite
Fannie/Freddie
Mortgage Risk Index (MRI) and House Prices in
Major California Metro Areas
Mortgage risk indices for most metro areas are below the national average, but are trending up
along with home price overvaluation.
Metro area/county indices for FHA not yet available.
However, FHAs California volume is disproportionately in Riverside-San Bernardino and the
Central Valley (defined in next slide), a signal of heightened default risk in those areas.


15
Fannie/Freddie MRI
Fitch Home Price
Overvaluation
Metro Area/County Oct-Dec 2012 Jan-Mar 2014 2012 2013:Q3
San Francisco 3.6% 3.9% 15-20% 25-30%
Oakland 4.2% 5.2% 10-15% 25-30%
Los Angeles County 4.6% 5.7% 10-15% 20-25%
Orange County 4.0% 4.8% 25-30% > 30%
Riverside-San Bernardino 5.0% 6.4% Sustainable 10-15%
San Diego 4.6% 5.3% 20-25% > 30%
National Average 5.0% 5.9% --- ---
Note: Fannie Mae MRIs are estimated using the Fannie Mae California state MRI and the Freddie Mac ratio of the metro area/county MRI to the
California state MRI. San Francisco includes Marin, San Francisco, and San Mateo counties; Oakland includes Alameda and Contra Costa counties.
Fitch estimates from Fitch Ratings, U.S. RMBS Sustainable Home Price and Economic Risk Factor Report January 2014.
Driver of Housing Policy: Homeownership Rates
Homeownership rate differences among minorities and whites are worthy of
national discussion, as are potential solutions.
According to the Census Bureau, the homeownership rates for Non-Hispanic
Blacks (Blacks), Hispanics, and Non-Hispanic Whites (Whites) are 43.2 percent,
45.5 percent, and 73.4 percent respectively.
Credit is a key input into the ultimate sustainability of any loan and the stability
of both neighborhood and national housing markets.
The credit profile for these groups is vastly different.
A 2007 Federal Reserve report to Congress on credit scoring found that the
median scores for Blacks, Hispanics, and Whites were 618, 670, and 737
respectively (medians interpolated from the Fed data).
The same report found credit scores to be predictive of credit risk for the
population as a whole and for all major demographic groups and further
credit characteristics included in credit history scoring models do not serve
as substitutes, or proxies, for race, ethnicity, or sex.
Blacks and Hispanics are expected to account for well over half of the growth in
households from 2010 to 2025.
16
While Leverage Has Increased, the Homeownership
Rate Has Been Stagnant since 1960















* Interpolated between 1950 and 1960
**Estimated loan term for 1970
***Adjusted for the 8.70% and 5.64% of loans that were seriously delinquent in 2010 and 2013
respectively (assumes 70% of homeowners have mortgages).
17
15
17
19
21
23
25
27
29
31
40%
50%
60%
70%
80%
90%
100%
FHA: average LTV (1940-
1967), median LTV (1980-
2013 (left axis)
US homeownership rate
(left axis)*,***
FHA: average term in
years (right axis)**
Risk Level and Default Rate Correlate for all Vintages
















*30 year, fixed rate, fully amortizing, fully documented, owner occupied loans
18
Combined LTV and FICO Highly Correlated to Default
Rate for Home Purchase Loans (2007 Vintage)
t
19
Combined LTV and FICO Highly Correlated to Default
Rate for Cash Out Refinance Loans (2007 Vintage)
t
20
Contentious Issues: Duty to Serve and Disparate Impact
One view: narrow underwriting prevents low-income
and minority borrowers from getting loans to the same
extent as higher income/non-minority ones.
Another view: the QM credit box is broad, deep, and pro-
cyclical during a boomall FHA (and Fannie and Freddie)
are eligible
High risk lending has a disparate impact on low-income and
minority families and neighborhoods
21
A Thought Experiment
To raise Black and Hispanic homeownership rates to the White
rate of 73.4 percent would require the origination of 10 million
30 year loans totaling $1.7 trillion with an average credit score of
630, a down payment of 3.5 percent and a median debt-to-
income ratio of 42%.
These loans clearly present high risks to homebuyers,
neighborhoods, lenders, mortgage insurers, and taxpayers.
35-30% default rate under stress
Defaults not evenly distributedgreater concentration in low-income and
minority neighborhoods
22
A Second Thought Experiment
A home loan with a 630 FICO, 4% down payment and 42% DTI.
FHAs advantages and cross subsidies allow substantial underpricing of
high risk loans compared to the private sector.
12% rate on a private 30 year fixed rate loan (rate based on Barclays
data) with a loan payment constant of 12.34clearly a high risk loan.
Amortized LTV after year 5 94%.
4.25% rate on an FHA 30 year loan with 1.75% upfront MIP and 1.35%
annual MIP with a loan payment constant of 7.25clearly still a high risk
loan.
This is due to fact that the reduced loan constant was allowed to be fully
capitalized into a 67% higher home price.
Amortized LTV after year 5 89%.
An alternative:
Allow the FHA home buyer to purchase a 32% higher priced home by reducing
the term to 15 years, the rate to 3.25%, and the MIP to 0.65% (loan payment
constant = 9.15).
This dramatically reduces risk to the borrower and neighborhood.
Amortized LTV after year 5 70%.
Year 5: three times the wealth building effect: $10,500 ($150,000 home price)
vs. $31,000 ($119,000 home price)
23
Insanity: doing the same thing over and over again
and expecting different results Albert Einstein
60 years of policy failureincreasing leverage will increase
homeownership.
FHAs failed effort to serve lower-income borrowers in the 1960s and early-1970s
was chronicled in Cities Destroyed for Cash.
The affordable housing mandates contained in the 1992 GSE reform act did not
end well.
Duty to Serve and Disparate Impact in the context of the pro-cyclical QM credit
box would have the same result:
Increased leverage bids up the price of existing housing, making it less
affordable, and leads to volatile home prices for those least able to cope.
Mortgage has become just another word for troubleinstead of a
straight, broad highway to debt-free ownership for families with the
ability, desire and discipline to become homeowners. (FHA 1935)
24
For more information
Go to: www.HousingRisk.org
My email: Edward.Pinto@AEI.org
Listen to our monthly National Mortgage Risk Index Briefing
calls: email Edward.Pinto@AEI.org
Next call: 10AM EDT on May 27
25