Spend 27 years in Congress and you’re bound to encounter more than one financial train wreck. But as Rep. Barney Frank, D-Mass., sees it, the meltdown in the U.S. housing market poses as much of a threat to the nation’s economic well-being as anything he’s encountered during his time on Capitol Hill.

More than 3 million homeowners will default on their mortgages this year, according to Moody’s Economy.com. That’s about 5% of all U.S. mortgages outstanding. Those defaults, in turn, are accelerating the pace of foreclosures and placing yet more pressure on housing prices - a vicious spiral that could hamstring the entire economy.

And as if that weren’t bad enough, mortgage behemoths Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), which together have a hand in half of all U.S. home purchases, have seen their share prices plummet amid rumors that they’ll soon require massive government aid to stay in business.

As chairman of the House Financial Services Committee, Frank is in the vanguard of the government’s response to the crisis. He spearheaded the much anticipated Housing and Economic Recovery Act, Congress’ most aggressive effort yet to beat back the onslaught of foreclosures and keep Fannie and Freddie afloat.

Money Magazine senior writer Janice Revell recently caught up with Frank in Washington a few days before President Bush signed the bill into law in late July.

Question: How on earth did the U.S. mortgage market get here?

Answer: We had too little regulation at a point of great financial innovation. Twenty years ago, most loans were made by someone who expected to be paid back by the borrower. And lenders who want to be paid back by the borrower are careful about who they lend to.

Then came this great innovation called securitization. Securitization means that I lend you money and quickly sell the right to be paid back by you to other people. Well, when the lender ceased to have an ongoing relationship with the borrower, a tremendous amount of banking discipline was lost. And it was much harder to replace than we thought.

Q. Where were the regulators during all of this? Why didn’t they step in?

A. Back in 1994, Congress gave the Federal Reserve the authority to ban irresponsible mortgages. Alan Greenspan, as a very committed anti-regulation conservative, refused - literally refused - to use that authority. Congress can give people authority; we can’t compel them to use it.

Ben Bernanke, to his credit, realized that it was time to use that authority. So he promulgated a set of rules on July 14 of this year to prohibit a lot of the mortgages of the type that got us in trouble. If Alan Greenspan had done 10 years ago what Ben Bernanke did this past July, we would have much less of a problem in subprime mortgages.

Q. Is the current mess a result of naive consumers being duped into horrible mortgages or is it a case of greedy consumers chasing cheap loans?

A. Some were misled, others took part in the deception. There were people, for instance, who lied about their incomes.

But we have made a mistake in this society. The assumption that everybody can be a homeowner is wrong. We pushed and encouraged people into home ownership - people who, in some cases, weren’t ready for it. You can’t act on wishes that are unrealistic without having negative consequences.

Q. You are the architect of new legislation aimed at stemming the rise of foreclosures. How is that going to work?

A. The initial approach taken a year ago by Treasury Secretary Paulson, who has handled this crisis very responsibly, was to get lenders to hold off on resetting adjustable-rate mortgages to a higher interest rate. The theory was that homeowners could refinance at a lower interest rate than the 11% or 12% rates they were facing.

But because of the drop in house prices over the past year, the problem now is that most of these people owe more on the house than it’s worth. Once the house is worth less than the loan, you can’t refinance. People hadn’t figured on that happening.

So we’re now telling lenders that if they agree to modify these mortgages so that the loan amount is equal to no more than 90% of the home’s current value, the Federal Housing Administration (FHA) will step in and guarantee the reduced mortgage against default. The homeowners will then be able to refinance into more affordable mortgages.

Q. But the lender still takes a big loss. Why would a lender go along?

A. We’re telling them, “Look, if the borrower defaults you’re going to take a loss anyway. We’ll guarantee that you’ll lose no more than you give up when you modify the loan.”

I think a lot of lenders will take advantage of that. And they understand that massive foreclosures are bad for the economy - and for them. Plus, this is purely voluntary. If you think you’re better off foreclosing on a homeowner, we won’t stop you.

Q. How much will this cost taxpayers?

A. The borrower’s mortgage is reduced by the lender, but the borrower gets no money from the government to pay off the new mortgage. Taxpayers are on the hook only if a borrower subsequently defaults on the reduced mortgage and the government has to take over the house.

Some of those houses won’t be worth as much as the mortgage that we had guaranteed. The Congressional Budget Office estimates that our proposal would cost taxpayers about $1.7 billion. But it would also prevent 500,000 foreclosures. That’s less than $4,000 for each avoided foreclosure.

Q. Why should responsible homeowners be forced to spend even a nickel of their tax dollars giving irresponsible borrowers a break on their mortgages?

A. Here’s why: Foreclosures do damage in concentric circles. The pain hits hardest on the people whose houses foreclose, but it also hits the entire neighborhood. If you’re a hard-working person making your mortgage payments and people around you are getting foreclosed, then your neighborhood starts to deteriorate.

The value of your home falls, and the entire city suffers because homes that used to generate property taxes are now eating up tax dollars. And when that happens, the whole economy suffers. So doing something about foreclosures helps the broader economy, not just the individual.

Q. Your legislation will also provide support to Fannie Mae and Freddie Mac should they need it. The tab could run tens of billions of dollars. Again, why should taxpayers bear the cost?

A. I believe Fannie and Freddie are better off than the market thinks. Over the long term the market is a very rational distributor of resources, but in the short term it can fall prey to hysteria. Sometimes you need to deal with that.

Part of the problem is rumormongering by short-sellers [investors who bet that a company's stock price will decline]. Our hope is that just by making U.S. financial support available, we’ll quiet the fears and eliminate any need for that support.

Q. This isn’t the first time we’ve seen housing prices fall. Why not just let the market work itself out?

A. Because it will cause tremendous pain that won’t be restricted just to housing. If the housing market simply deteriorates, the problem won’t just be foreclosures. Banks will fail. Pension funds won’t be able to pay workers their pensions - because they all own these securitized mortgages. Packaged mortgages have now become such a major part of the economic landscape that a massive failure of them would have serious consequences around the world.

Q. IndyMac Bancorp failed in July, the third-largest bank failure in U.S. history. Are we going to see more bank failures before all this plays out?

A. I’m sure there will be more bank failures, but we shouldn’t panic about that. Banks fail. That’s why we have deposit insurance. I don’t think we’re at the point where we’re going to have a rash of bank failures of the magnitude that could cause systemic failure.

Q. What has to happen to make you confident we’re not going to relive this mess all over again someday?

A. The Federal Reserve should be given the authority to exercise regulatory authority over investment banks. The time has come to regulate the securitization process. We need the kind of regulation that diminishes abuses but doesn’t stifle economic activity.

And we basically have to tell people who want to make mortgage loans something terribly radical: Do not lend money to people who can’t pay it back.

Credits: CNNMoney.com

• For the best rates on a conforming loan, people need a 20% down payment and a FICO of 750 or higher, Cecala said. Not surprisingly, very few people meet those requirements, he added. Risk-based pricing by Fannie Mae and Freddie Mac will cause those who don’t meet those basic parameters to pay more for their mortgage. So even if you’re able to get a mortgage with a 640 credit score, the loan terms will be more expensive, he said — and if you have a low credit score you’ll probably have to put more money down than someone who has better credit.
• Borrowers who aren’t able to put 20% down will likely have to purchase mortgage insurance, and to get that there’s another set of requirements that must be met. Insurers are being “very cautious” with regard to what they will insure, Habetz said. Requirements differ at each mortgage-insurance firm, but if a home is in a market where prices are declining, borrowers may be asked to put down 10%.
• Borrowers who are eligible for a loan backed by the Federal Housing Administration may be able to put down as little as 3%. That has become a more popular option for those with weak credit scores.
• Most nonconforming jumbo loans today are being made by portfolio lenders, who keep the loans on their books, Cecala said. Consumers may do well by doing some legwork and comparing rates at local community banks, which have been “coming out of the woodwork” to offer competitive rates, he added.

“There’s money to be had, you just have to jump through hoops to get it,” Cecala said.

Credit: MarketWatch.com

The good news: Mortgage giant Fannie Mae is taking steps to shore up its finances. The bad news: You’re going to pay for it when you take out a mortgage.

Fannie plays a central role in the market for home mortgages by purchasing loans, securitizing them and selling them to investors. In announcing announcing a $2.3 billion loss on Friday, it also said it would make major changes that could have a significant effect on mortgage liquidity and pricing.

The company said it will increase its fees, stop buying certain high-risk loans and charge a higher risk premium for buying loans in the declining market.

“[These actions] have raised the costs of mortgage credit and reduced its availability,” said Mark Zandi, chief economist for Moody’s Economy.com. “Policy makers had been hoping they would move forward to provide more credit and now they’re just hoping they don’t pull back.”

The increases were inevitable, according to Keith Gumbinger of HSH Associates, a publisher of mortgage loan information.

“The cost of mortgage credit is getting pushed higher by the issues in the marketplace,” he said. “They can’t reduce their market exposure and that means more expensive mortgages.”

Fannie increased fees for some loans by a quarter of a percentage point, based on borrowers’ credit scores and the amount of their down payments. It will charge, for example, 1% (up from 0.75%) for a buyer with a credit score of 680 paying 20% down.

And Fannie doubled its “adverse market delivery charge” to 0.5%. That is an across-the-board fee assessed against every loan Fannie buys, according to a Fannie spokeswoman. Fannie first instituted the charge this spring.

“It’s very negative,” said Lawrence Yun, chief economist for the National Association of Realtors. “Any time there’s an additional imposition of fees in obtaining a mortgage, it knocks some potential buyers out of the market.”

Fannie’s smaller cousin, Freddie Mac, which also announced a big loss this week, has been taking similar steps to shore up in finances and reduce its exposure to risky loans.

The additional fees imposed by Fannie will hit newcomers particularly hard, according to Yun. First-time buyers are usually most on the margins and struggling to afford a home purchase. The added fees will be passed on to borrowers and could mean quarter-point increases in interest rates.

Reducing the number of first-time buyers can have a domino effect on the market. Existing homeowners looking to trade up to bigger, more expensive homes may postpone doing so because they can’t sell their present home.

Fannie will also eliminate buying Alt-A loans by the end of 2008. Alt-A loans, a category between prime and subprime, accounted for about 11% of the company’s loans during the last years of the boom. They have been used mostly by people who couldn’t or wouldn’t document their incomes, their assets or both. These buyers will find it harder to obtain financing once Fannie stops buying the loans.

According to Yun, however, the cutback in Alt-A will hurt people buying second homes to rent out or resell, rather than first time homeowners.

“These are people who often rely on their good credit to buy investment properties putting little or no money down,” he said.

But removing some of them from the market will decrease demand in a market already struggling with high inventory.

Fannie and Freddie, as private companies created and sponsored by the government, have to foster home ownership while satisfying their shareholders. They have to maintain profitability or risk triggering a government rescue.

“They were created to provide liquidity in times of crisis,” said Yun. “If they don’t do that, what’s the point of having Fannie and Freddie in the first place?”

Credit: CNNMoney.com

Mortgage finance giant Freddie Mac, in a sign of continuing woes for the housing and financial markets, reported a much bigger than expected second quarter loss and slashed its dividend on Wednesday.

Freddie lost $821 million, or $1.63 a share, in the quarter. Analysts surveyed by Thomson Reuters had forecast it would trim its loss to 41 cents a share from the 66 cent-a-share loss in the first three months of the year. The company earned $729 million, or 96 cents a share, a year ago.

The company announced it would cut its quarterly dividend to 5 cents a share or less, subject to a final decision by its board, from 25 cents a share in an effort to save capital. Losses have strained Freddie’s capital, and the dividend cut should save the company more than $500 million a year.

Freddie Mac CEO Richard Syron told investors on a conference call that conditions in the housing market will get worse. Freddie expects prices of the homes in its inventory will fall 18% to 20% from their peak, rather than the 15% drop it previously expected.

“Today’s challenging economic environment suggests that the housing market is far from stabilizing,” Syron said. “The long and short of it is that we now think that we are half-way through” the home price decline, he added.

Shares of Freddie plunged 13% in late morning trade. The decline also dragged shares of Fannie Mae, which operates in the same business as Freddie and is set to report quarterly results on Friday, down 11%.

Freddie said its estimated core capital slipped to $37.1 billion at the end of the quarter from $38.3 billion at the end of March. That capital level is about $2.7 billion above the level it agreed to meet with its federal regulator.

Provisions for credit losses more than doubled to $2.5 billion from $1.2 billion in the first quarter. The reason: increases in the delinquency and foreclosure rates of the mortgages Freddie owns and guarantees, as well as the continued declines in home prices.

Those provisions for credit losses caused the company to lose $1.4 billion on the guarantees it makes on loans for single-family homes - about triple the $458 million loss on that line in the first quarter. The company made $129 million on those guarantees in the year-ago period.

The company saw losses soar even though its net interest income, the difference between interest paid and interest income soared to $1.5 billion from $793 million a year ago, due to lower interest costs for the firm in the just completed quarter.

That rise in net interest income was more than offset by the $3.3 billion hit in investment activity due to the reduced estimated value of its holdings. That’s up from a loss of $540 million a year earlier.

About $1 billion of the most recent investment loss was caused by the decline in the value of Freddie’s mortgage securities, which are backed by subprime mortgages or so-called Alt-A home loans made to borrowers who did not provide full or any verification of income or assets.
Central role in mortgage markets

Freddie and Fannie Mae, which were set up by the government to provide funding for the mortgage markets, have become the primary source of capital for banks and other lenders making home loans. They are seen as crucial to the recovery of the housing and credit markets.

But investor anxiety about the firms has driven shares of Freddie down by 66% between June 16 and Tuesday’s close, while Fannie shares lost nearly half their value during the same period. It also prompted Congress to pass a rescue measure for the firms, allowing the Treasury Department to loan them an unlimited amount of cash and even buy their shares if necessary.

Syron was asked Wednesday if Fannie and Freddie, known as government sponsored enterprises or GSE’s, can continue to operate in a way that both helps the housing market and makes the profits that shareholders demand. He said he believes they can continue to serve both missions going forward, despite these losses.

“I don’t think we’re at a point that the model doesn’t work anymore,” he said. “I think we are a point where the model is more stressed.”

“I think virtually everyone, including our critics, would say that this would be an extremely ugly mortgage market if you didn’t have the GSE’s in it,” Syron said.

Credits: CNNMoney.com

Spiraling stock losses. A government bailout. A new regulator. These are the highlights in what is sure to go down as one of the most tumultuous months in the history of mortgage giants Fannie Mae and Freddie Mac.

But on the heels of changes signed into law July 30, it’s unclear what the new rules will mean for the future of District-based Fannie Mae and McLean-based Freddie Mac.

The act makes explicit the government’s backing of Fannie and Freddie, which had merely been implied up until now. It also creates the Federal Housing Finance Authority, a new regulator for the government-sponsored enterprises, or GSEs. The explicit financial backing expires at the end of 2009, though it’s not clear how much impact it will have on Fannie and Freddie’s ability to lure investors.

Historically, the GSEs have been able to raise money easily because investors interpreted the implicit backing as making its bonds pretty much as safe as Treasury bonds, but with higher yields. Will an explicit backing make them any more appealing?

“I don’t think it’ll have much effect,” said Robert Losey, professor at American University’s Kogod School of Business. “Most people viewed the implicit backing as almost as good as the explicit backing.”

While selling bonds might not be a problem, investing the proceeds could be, said Gerald Hanweck, chair of the finance department at George Mason University School of Management. “If no one is buying homes, then they can raise all the money in the world and it won’t do anything to increase liquidity in the housing market.”

The Treasury’s backing of Fannie and Freddie is temporary, but the new regulator is here to stay. If the Federal Housing Finance Authority shortens the leash on the GSEs, it could have broad effects. One likely move: requiring the companies to hold more capital.

“Whether it’ll be a big move in the next year or a more gradual move is hard to predict,” Losey said. “But there will be pressure on the regulator to do that.”

Fannie and Freddie’s capital requirements have been much lower than that of banks, giving them proportionately less cushion to absorb losses. While raising their capital levels would calm investors’ nerves, it also would constrain growth at the firms, Losey said.

The regulator also will be under pressure to look more closely at Fannie and Freddie’s portfolios. As home prices continue to fall, the regulatory scrutiny could make the GSEs more likely to mark down the mortgages in their portfolios to fair market values — which would appear as losses, Losey said.

Hanweck isn’t as confident about the regulatory changes. “Their old regulator had a lot of power to change things, and didn’t. I don’t see that a new regulator is going to do it either. These are powerful companies with lobbying groups that work the regulator directly — and work the Congress that oversees the regulator. I don’t see that changing,” he said.

For its part, Freddie spokesman Douglas Duvall said the company “looks forward to playing a constructive role as the process of carrying out the legislation turns to rule writing.”

While the new law made some important changes, it still leaves many unanswered questions about Fannie and Freddie, said Stephen Ryan, head of the government strategies group at McDermott Will & Emery.

“It’s untenable to have an incomplete answer to the question: What is the relationship between the GSEs and the government?” he said. “I don’t think this bill answers that. It was just a Band-Aid over the implicit guarantee.”

He predicts that further debate about this issue will begin almost immediately and that Congress could further define the GSEs’ relationships with the government next year.

Many have called for Fannie and Freddie to become either fully private or fully public institutions, but Ryan doesn’t think it’ll happen. “They will always be hybrids, just more clearly defined hybrids,” he said.

Credit: BizJournals.com