Freddie Mac, one of the biggest investors in U.S. mortgages, plans to toughen its standards and stop buying certain types of risky loans that have been linked to a high number of delinquencies and defaults.
The decision, announced yesterday, is the latest sign of the deep problems roiling the subprime mortgage market, which caters to borrowers who could not qualify to buy a house with a conventional loan, including people with blemished credit records.
During the recent housing boom, subprime lenders eager to cash in on the home-buying frenzy relaxed their standards. They allowed borrowers to take out mortgages with low teaser rates that ballooned after the first few years. Now that the higher rates are kicking in, many borrowers are struggling to make their monthly payments, and dozens of small lenders are losing money, shutting down or filing for bankruptcy protection.
Freddie Mac's decision to clamp down on these types of mortgages signals heightened alarm about the course of events. If the damage is not contained, a crippled mortgage industry could destabilize the economy, several economists said.
"This is one of the biggest voices in the mortgage market saying in a very public way that the mortgage and housing markets are very troubled," said Mark Zandi, chief economist at Moody's Economy.com.
The trouble is most apparent in the fourth-quarter mortgage delinquency rate, which climbed to its highest level in four years, the Federal Reserve said yesterday. The portion of loan payments at commercial banks that were at least 30 days overdue rose to 2.11 percent in the quarter, up from 1.72 percent in the previous three months. Other measures of mortgage delinquencies have also increased recently.
All indications are that delinquencies are rising faster in 2007. Typically, if there's a surge in delinquencies, defaults follow. Many blame the surge on subprime mortgages, which, according to the Mortgage Bankers Association, made up about one-fifth of all new mortgages last year.
That's why Freddie Mac plans to apply stricter standards to subprime mortgages written on or after Sept. 1, 2007, that have "a high likelihood of excessive payment shock and possible foreclosure."
Freddie Mac executives singled out the so-called 2/28 and 3/27 adjustable-rate mortgages, which offer low rates for the first two and three years of the loan, respectively, and then adjust to a much higher rate for the remaining 28 or 27 years.
Freddie Mac, based in McLean, does not buy many subprime loans directly from lenders, but it is fairly active in investing in securities that are backed by such loans. Freddie holds about $180 billion of those securities and says about half of those would not meet its new criteria.
The company will buy securities backed by the 2/28 and 3/27 loans only if the borrowers qualify for the highest rate the loan can have. For instance, if the teaser rate is 2 percent but eventually kicks up to 8 percent, the borrower must qualify for the 8 percent loan.
"What was appropriate for people in the past is not appropriate under the changed economic circumstances," Richard F. Syron, Freddie Mac's chairman and chief executive, said in an interview.
When the housing market was robust, subprime mortgage lending was a lucrative business that quickly attracted too many players, said Matthew Howlett, an analyst at Fox-Pitt, Kelton in New York.
When the housing market cooled and interest rates edged up, competition among lenders intensified, Howlett said. Many lenders reached out to even riskier borrowers, relaxed their lending standards and offered more tantalizing terms.
Even exotic mortgages, such as interest-only loans, that were once extended only to the most credit-worthy borrowers were offered to high-risk borrowers as well, layering risk upon risk.
"If you could fog a mirror, you could get a loan," said Brian Horey, a partner at Aurelian Partners, a private investment partnership in New York. "But once property values stopped going up sharply, the true economics of these loans became apparent, and over the last six months, these loans have become undone very quickly."
That's because when the housing market slowed, homeowners could not easily sell or refinance their homes if they had trouble making payments, Horey said.
To protect future borrowers from "payment shock," Freddie Mac will no longer buy securities backed by subprime loans that lack documentation of the borrower's income and the value of the property being financed.
The company also is developing a standard to limit the purchase of securities backed by loans in which the income was stated but not documented.
Freddie Mac also wants lenders to consider the cost of taxes and insurance when they write mortgages.
Fannie Mae, Freddie Mac's larger competitor, said it is waiting for guidance from federal regulators about how to treat nontraditional mortgages.
If lenders and regulators follow Freddie Mac's lead, there would probably be even more people who would not be able to refinance their way out of their problems, which would lead to even more delinquencies initially as the market adjusted itself, several economists said.
The Mortgage Bankers Association questioned Freddie Mac's decision, saying the people who will be hardest hit will be first-time, underserved or minority homebuyers who will suddenly find themselves without access to credit.
"We worry that people who could buy a home today won't be able to qualify for credit in the future if these kinds of subprime loans are driven from the market," said Kurt Pfotenhauer, one of the association's senior vice presidents.
But others are praising Freddie Mac's decision, including Sen. Christopher J. Dodd (D-Conn.), chairman of the Senate Committee on Banking, Housing and Urban Affairs, who called on Fannie Mae and the Federal Home Loan Banks to follow Freddie Mac's lead.
"This is a responsible standard that ensures that these borrowers will have the ability to repay their loans, thereby protecting their home equity," Dodd said in a statement. "As I have said repeatedly, there is no justification for providing fewer protections to vulnerable subprime borrowers, who are disproportionately black and Hispanic, and less able to withstand payment shocks."