By David S. Hilzenrath
Washington Post Staff Writer
Friday, December 7, 2007
For a glimpse of the risks that infected the mortgage business in recent years, consider a small slice of what happened at Freddie Mac, the giant home-loan investor chartered by the government to bring stability to the housing market.
Before the era of easy credit, home buyers were ordinarily required to come up with down payments, which gave them an equity stake in their property.
That equity reduces the danger of foreclosure, and federal law prohibits Freddie Mac from buying mortgages that cover more than 80 percent of a home's value -- unless the loan comes with a safety net, such as an insurance policy that would kick in if the borrower defaults.
However, in recent years, Freddie Mac permitted home buyers to borrow all or part of the remaining 20 percent by using second loans, called "piggyback" loans, with no safety net.
As early as 2005, an industry group protested that the practice was designed to get around the law and should be stopped.
Regulators allowed it to continue, and Freddie Mac's financial disclosures were silent on the subject until last month, when the company noted that such arrangements could leave borrowers more susceptible to foreclosure.
"[A]s home prices increased during 2006 and prior years, many borrowers used second liens . . . thus avoiding requirements under our charter," Freddie Mac said in a quarterly financial report.
Nothing prohibited Freddie Mac from taking on uninsured piggyback loans, Patricia Cook, Freddie Mac's executive vice president and chief business officer, said in an interview yesterday.
"I don't think we viewed it as our role or responsibility to say to the market that seconds were inappropriate," Cook said.
Loans in piggyback arrangements are "a very small piece" of the company's investment portfolio, and their performance "is markedly better than any of the toxic mortgages that have been originated," said Anthony S. "Buddy" Piszel, Freddie Mac's chief financial officer.
Freddie Mac made the recent disclosure about the effect of second loans because the company has been trying to improve its financial reporting and "felt that it was important information for the market to have," spokesman Michael Cosgrove said.
The purchase of piggyback loans is one of many factors that has left Freddie Mac exposed to potentially larger losses as a nationwide debt bubble deflates. The McLean company turns out to have been more vulnerable to a downturn in housing prices than it appeared.
Last month, Freddie Mac announced a $2 billion loss for the third quarter. Since early October, the company's stock has dropped 41.5 percent, erasing billions of dollars of shareholder wealth. At a time when some policymakers hoped it would help ease a credit crunch by serving as a loan buyer of last resort, Freddie Mac was selling mortgages to shore up its own financial condition. Last week, it cut the dividend it pays stockholders by half and borrowed $6 billion from investors to meet federal capital requirements.
Like its competitor Fannie Mae, Freddie Mac plays a major role in the nation's housing finance system by packaging pools of mortgages into securities for sale to other investors and by buying mortgages itself.
Freddie Mac's problems are similar to those weighing on many of the nation's largest financial institutions. In pursuit of profit, and to retain market share, it invested in riskier loans. Some came with the option of low monthly payments that escalated over time. Some required no information about a borrower's income or assets. In many cases, the loans made it possible for people to buy homes they could not otherwise afford.
Now, borrowers are defaulting, foreclosures are mounting, home prices are falling, and easy credit is drying up, feeding a downward spiral.
Freddie Mac's diversification into certain types of alternative loans took a big jump in 2005, well after a 2003 accounting scandal exposed deep flaws in the company's internal controls and a new chief executive, Richard F. Syron, was brought in to clean up the mess. In its annual report for 2005, the company said that it expected the alternative loans to default more often than traditional loans and that it had factored in the risk.
Freddie Mac has the potential to influence lending practices by setting conditions for the loans it accepts. But company executives said yesterday that Freddie Mac's power was eroding as investors entered the market.
Amid a loosening of industry standards, Freddie Mac could not afford to sit back and let the market pass it by, the executives said.
"I think what happened over time is, we found that our own caution was making us less and less relevant, and we weren't sure, quite frankly, that our competitors, you know, on the street were being crazy," Piszel, the chief financial officer, said.
"Could we have run for the hills and said we're not going to do any of that?" Piszel asked. "What if things didn't go down? We would basically be just taking our whole future and giving it away."
This year, as the market deteriorated, Freddie Mac's investment in alternative loans grew. For the first nine months of 2007, nontraditional loans made up about a third of Freddie Mac's mortgage purchases, up from almost a quarter in the first nine months of 2006.
Unlike most other players in the mortgage business, Freddie Mac is required to operate under a congressional charter that imposes such restrictions as the 80 percent rule.
That requirement was meant to insulate the company from losses.
"Our principal safeguard against credit losses for mortgage loans" -- apart from insurance and the like -- "is provided by the borrowers' equity in the underlying properties," Freddie Mac said in its annual report for 2003.
The relationship between loan size and property value, known as the loan-to-value, or LTV, ratio, is a key measure of loan quality. The company features it in its financial reports, and Syron, the chief executive, cited it in his letter to shareholders for 2006. However, the ratios the company reported over the years did not reflect the combined total of multiple loans on the same property.
Cosgrove, the company spokesman, said they weren't required to.
The company described the potential impact of second loans last month, devoting three sentences to the subject in an 81-page report on its latest financial results.
Including second loans, Freddie Mac estimated that about one in seven of the single-family mortgages it held on Sept. 30 had total loan-to-value ratios of more than 90 percent, compared with one in 20 if it excluded the piggyback loans.
"In general, higher total LTV ratios indicate that the borrower has less equity in the home at the time of origination and would thus be more susceptible to foreclosure in the event of a financial downturn," Freddie Mac said.
The company offered a reassuring note several months earlier in its annual report for 2006. Freddie Mac said loans with "lower levels of borrower equity" carried insurance or other financial backstops.
Freddie Mac executives said that point was framed in terms of the company's loan-to-value ratio, which excludes piggybacks, and not total loan-to-value, which includes them.
"I would chalk that up to less precision in the disclosure," Piszel said.
Piggyback loans became a point of contention in 2005, when a trade group for providers of mortgage insurance raised the issue in a letter to the Office of Federal Housing Enterprise Oversight, the government agency responsible for monitoring the financial soundness of Freddie Mac and Fannie Mae.
The two companies "have of late become major purchasers of first liens that are part of piggyback mortgages constructed solely to evade the charter requirement," Suzanne C. Hutchinson, executive vice president of Mortgage Insurance Companies of America, said in the letter.
Hutchinson urged the OFHEO to bar Freddie Mac and Fannie Mae from buying loans in piggyback arrangements where the combined loan-to-value ratio exceeded 80 percent.
For the mortgage insurers, the issue was more than academic: piggybacks were cutting them out of the picture.
OFHEO officials declined to comment on the complaint and would not discuss their communications, if any, with Freddie Mac about piggyback loans.
The company's "disclosures are subject to OFHEO's review and comment as part of our regular supervisory process," said Corinne Russell, an OFHEO spokeswoman. "We do not comment publicly on our supervisory discussions."
The issue has become harder to ignore as home prices have declined, eroding whatever equity borrowers had in their homes.
Even excluding piggybacks, the percentage of loans with high ratios has been creeping up this year.
At the end of the third quarter, 17 percent of Freddie Mac's mortgage investments had ratios of more than 80 percent. Overall, for 1 percent of Freddie Mac's holdings, the loan-to-value ratio was more than 100 percent, meaning that the real estate serving as collateral for the loans was worth less than the loans.
Freddie Mac is predicting it will have to set more money aside to cover losses on mortgages made in 2006 and 2007, partly because they had "lower amounts of third-party insurance coverage and higher loan balances at the time of origination than our historical experience," according to its latest quarterly report.