For a safe mortgage system, every participant needs to have capital at risk, or what the industry calls skin in the game.
When house prices began rising a lot in 2004—double digit annual growth in certain fast-growing markets—lenders pressed the GSEs to relax the long-standing down payment requirements as competition heated up. After all, why should a borrower have to make a sizeable down payment if the local housing market was going to build the equity in relatively short order? Borrower equity was growing at impressive rates, driving the risk of mortgage default to miniscule levels.
Other aspects of the traditional underwriting equation, the three C’s of collateral, capacity and credit, were under pressure as well. Requirements for borrower credit scores and income relative to debt were gradually relaxed, and appraisals often had a rosy appearance. A truism in the mortgage industry was that rising house prices covers the sins of the underwriters.
Through 2006, house prices climbed still higher and amnesia set in. The forecast was for full sun in the mortgage market, and just about everybody—from lenders to politicians to consumer groups—stopped worrying about risk and jumped on the pro-homeownership bandwagon. Worse, they were quick to accuse the GSEs of price gouging for charging fees when actual current-year losses were exceedingly low.
Attention dangerously turned from risk management to the stark observed differences in homeownership rates. It wasn’t long before the GSEs—and their proprietary underwriting algorithms—were viewed as the scrooges responsible for the lull in the upward march of homeownership. No longer valued as the rainy day fund for the mortgage system, GSE guarantee fees were now seen as unnecessary barriers to homeownership.
The collective thinning of risk coverage—for borrowers, lenders and GSEs—was largely invisible until 2007, when the 10-year escalation of house prices suddenly went bust. The subsequent crash caused the home equity cushion for many borrowers to evaporate, driving their mortgages underwater. Undoubtedly, some could have weathered the drop in house prices had they not previously monetized the equity windfall in their homes by obtaining cash-out refinances and second liens.
Or, if they had made sizeable down payments to start with.
As all these factors wreaked havoc on household balance sheets, they devastated Freddie Mac’s as well.
Thanks to the price wars with Fannie Mae from time to time and then the competitive onslaught from Wall Street, Freddie’s financial margins to cover expected mortgage losses were driven to unsustainable lows.
Excerpted from chapter 3, Securitzation Breakdown, Days of Slaughter, Inside the Fall of Freddie Mac and Why It Could Happen Again (JHUP, 2017)