Freddie - Floyd Norris: From virtuous circle to vicious credit cycle
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Floyd Norris: From virtuous circle to vicious credit cycle
By FLOYD NORRIS
Thursday, November 22, 2007
NEW YORK: It's not just subprime anymore. Freddie Mac, the U.S. government-sponsored mortgage lending enterprise, said this week that enough borrowers were defaulting on loans made this year or last that it needed to mark down the value of the loans by $1.2 billion.
How many of those loans were subprime?
None. But that does not make the losses any less real.
Freddie Mac historically did not buy subprime loans. But that did not stop it from buying some truly dubious loans. The borrowers may not have qualified as subprime, but many of the loans should have raised questions before they were made.
"The underwriting standards declined," said Anthony Piszel, chief financial officer of Freddie Mac. "That was across the board."
Those who made loans and expected to sell them quickly did not care much about assuring that the loans would be repaid. It turns out that the financial wizards who made it easy to transfer risk also guaranteed that more risks would be taken. They produced such innovations as Nina loans, which, Piszel said, "found their way into prime space."
Nina loans?
The abbreviation stands for "No income, no assets." It does not mean the loans went to people without either income or assets, only that the borrowers were not asked if they had either. I had known about "stated income" loans - also known as "liars' loans" - in which the bank took a borrower's word for how much he or she earned. But I had not realized you could borrow money without even being asked about your income.
Starting this month, Freddie will not guarantee such loans, which appear to default more often than other loans.I didn't know Freddie could buy any of that trash!
Each week seems to turn up more evidence of just how wide open the credit markets were, particularly for mortgages. Freddie Mac reports that two-thirds of the reserves it has set aside for bad loans come from loans given in 2006 and 2007.
Freddie's principal business is buying loans, guaranteeing them and then selling securities backed by those loans. It is the only link in the chain that has any reason to care about credit quality, and it appears that it did not care very much.
A kinder way to look at it is that competition forced the company to lower its standards. Either way, Freddie this week released data showing how its standards eroded. None of the loans on its books from 2003 or earlier call for payments of interest only. Almost a quarter of the loans it bought this year had that characteristic.Again, how could interest-only loans end up on Freddie's balance sheet?
Freddie's report of a $2 billion loss in the third quarter sent its stock reeling and took with it that of its cousin and chief competitor, Fannie Mae. Both are likely to have to raise large amounts of capital to keep buying loans. That capital will not come cheap and will make it more important than ever that they have good profit margins. That, in turn, implies higher borrowing costs for those who do get mortgages.
Freddie needs to raise capital, in part because it expects to have a very bad fourth quarter and also because it has so far refused to take some losses. While it did not guarantee subprime loans, it did help to finance them by purchasing securities backed by subprime mortgages. Freddie says it will not sell the securities and expects them to pay off in the end, so there is no need to report a loss on them. But it could not possibly sell them now for anything approaching what they cost.
Further, the $1.2 billion in write-downs on recent mortgages, while less than a quarter of one percent of the mortgage pool in question, are only a start.
Those losses are from loans that are already in foreclosure or close to it, or from homes where default seems near because of job losses.
The virtuous circle of 2005 clearly made the economy appear stronger. Easy credit helped raise home prices. Rising home prices made it appear that loans to risky borrowers were safe and encouraged people to take out new loans to finance consumption. That spending helped the economy grow and persuaded companies to hire.
Or, as Piszel told me, "As long as house prices were going up, it cured all evils."
The securitization market for mortgages is almost dead, save for those guaranteed by Fannie and Freddie. Banks that make loans now know that they may have to hold on to them, a fact that encourages prudence and discourages lending to those who most need loans.
Now we face the threat of the opposite, vicious, circle. Tight credit puts downward pressure on home prices. Lower home prices make it harder to refinance mortgages even for those with good credit, and discourage spending. That can cut corporate profits and lead to layoffs.
Today is known as "Black Friday" in U.S. retailing: the day after Thanksgiving that marks the start of holiday shopping season and that is supposed to be the day retailers finally get "into the black," or turn a profit.
But there are fears that this year the color black will instead describe consumer sentiment. During the past seven months, the Standard & Poor's 500 index is down 5 percent, while the S&P 500 department store index is off 42 percent.
Banks have not tightened up very much on credit cards. If access to credit were the only issue this holiday season, then sales would be healthy. But if consumers are scared, what began as a subprime crisis could spread to the entire U.S. economy.
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