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  • Fannie and Freddie Did Not Cause This Crisis
    One factor that seems to be overlooked in this and most analysis is the profit motive that drove sub-prime and Alt-A lending. Everyone in the chain – Loan Officers, Mortgage Brokers, Retail and Wholesale Mortgage Bankers, Aggregators, Securitizers (which includes FNMA and FHLMC) and Broker/Dealers – all parties made more money on higher risk business than lower risk business. At least, that was the case before the bubble burst. And, after the bubble burst, not all parties had an equal stake in the performance of the assets. Arguably, Loan Officers and Mortgage Brokers have zero liability for the performance of the product that they originate, aside from the possibility that they could lose their job.
    The simple fact is that there was more money to be made by talking a borrower into a zero down payment stated income loan than a fully documented loan with a healthy down payment. The same can be said about Payment Option ARMs, loans with prepayment penalties, Non-Owner Occupied loans, etc. So, not only could an originator make more money because they could do more loans with aggressive guidelines, they could make more money on each loan when a more aggressive loan program was used.
    It has become typical over the past decade or so to originate loans with no fee or minimal fees charged to the borrower. So how did everyone make money in the loan origination business? The asset must be worth more than face value in order for everyone in the daisy chain to make money. As is typical with all fixed income instruments, there is a price/yield tradeoff. A higher rate instrument is worth a higher price. This relationship is not linier in mortgages, however, because as rate increases, prepayment risk increases, and the prospect of realizing the benefit of higher yield over time decreases. So, an end investor will be reluctant to pay more and more for higher and higher rate loans. Typically, fixed rate fully documented, low loan to value A-paper mortgages with no prepayment penalties tend to “top out” somewhere around 103% of face value, including the value of servicing. That means that if the borrower is not charged a fee, there is 3% of the loan balance to split between all of the players in the chain. By contrast, Alt-A, Payment Option ARMs and sub-prime loans were worth far more than less exotic loans before the bubble burst. Payment Option ARMs received whole loan bids as high as 106% of face value in 2005. True sub-prime loans reached prices as high as 107% earlier in the decade.
    This pricing phenomenon motivated many players in the industry to focus on higher risk products and build incentive and compensation systems to drive business to these product categories. The borrower wants to put 20% down and can fully document income? Why not explain the advantages of higher leverage, lower payment structures, maybe point out that they “qualify” for a much more expensive house than the one that they have in mind if they employ modern financing techniques?
    This profit motive was a huge part of the equation, and FNMA and FHLMC were no exception. Higher risk products earned the GSE’s higher guarantee fees and allowed them to compete for market share between themselves and the GSE alternatives (Wall Street Broker/Dealers).
    Oct 05 10:59 am |Rating: 0 0 |Link to Comment |View article

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