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Fannie's Perilous Pursuit of Subprime Loans
Although the deals discussed in Mudd's memos were small in relation to the overall scale of Fannie Mae's business, they reflected the company's appetite for subprime and Alt-A mortgages. The company had a long and deep involvement in this market through a different form of investment.
Instead of buying the loans and securitizing them itself, Fannie Mae had invested in securities packaged by others from pools of these loans. Going back at least as far as 2002, Fannie Mae had taken on tens of billions of dollars of such securities, according to regulatory data.
Fannie Mae's investment in Alt-A and subprime securities issued by others would later prove costly. But in Mudd's January 2007 report, as he reviewed the company's business, they didn't even draw a mention.
A month later, Fannie Mae management outlined a plan to acquire $11 billion more in "subprime/non-prime mortgages" in 2007 and expressed confidence in its ability to handle the risk.
The company had "approached its expansion of this business cognizant of the relatively weak credit performance of recent subprime originations, which were affected by issues relating to underwriting quality, home price de-appreciation . . . and risk layering," one February 2007 document said, referring to loans with multiple risky characteristics. "However, management expects improvement in the quality and credit performance of subprime mortgages originated this year."
By March 2007, when Mudd sent the board an update, major subprime lenders were failing, delinquency rates were climbing, and the emerging crisis was impossible to ignore.
The subprime sector "is in partial meltdown," Mudd wrote. He reported to directors that Fannie Mae's investment in subprime mortgage assets totaled about $55 billion.
Mudd told the board that Fannie Mae had run its subprime portfolio through a stress test to determine the losses in a hypothetical scenario that involved a two-percentage-pointrise in interest rates and two years of 5 percent declines in home prices. The resulting prediction: "zero credit losses net of earnings."
Mudd remained so sanguine about Fannie Mae's outlook that he asked the board to consider giving up its special status as a government-sponsored enterprise -- an advantage that helped the company borrow money at low rates by leading investors to believe the government stood behind its obligations.
Since then, the government's more explicit support has provided a crucial backstop for the struggling company.
As it turned out, Fannie Mae did not buy as many subprime loans as it intended in 2007 because few of them met its criteria and the market worsened, Lund said. The subprime loans the company did buy in 2006 and 2007 performed as expected, Faith said, declining to say whether they had produced profits or losses.
But the continuing purchases of securities backed by loosely underwritten loans have been a source of trouble.
Though the deterioration in home prices has not been as extreme as the hypothetical "stress test" scenario Mudd cited in his memo last year, Fannie Mae has incurred losses of $3.4 billion on securities backed by subprime and Alt-A loans since the beginning of 2007, the company reported last week. Alt-A loans accounted for almost half of the red ink the company attributed to foreclosures and other bad loans during the quarter ended June 30.
Faith declined to discuss the stress test.
At the end of June, Fannie Mae owned or guaranteed $388.3 billion of Alt-A and subprime mortgage investments. In comparison, it said its capital -- the financial cushion that enables it to absorb losses -- totaled $47 billion, which exceeded the government's minimum requirement by $9.4 billion.
In his statement to The Post, Mudd said Fannie Mae's Alt-A investments have been hurt "by the most severe decline in home prices since the Great Depression." Making matters worse, the investments are concentrated in states "where home prices have fallen further and faster than in the rest of the nation," he said.
This month, Fannie Mae said it would stop taking on new Alt-A loans by the end of this year.