Freddie Mac, one of the nation's largest buyers of home mortgages, has taken the first step to distance itself from subprime lending, as are other lenders large and small. Shutting off the mortgage spigot is likely to further cool the already chilly housing market.
The company has announced a series of tough new standards for the loans it purchases, and makes it clear it plans to pass on a number of riskier types of loans that have been linked to increased default rates.
Subprime loans are targeted to homebuyers with little or no established credit. They often offset the increased risk with much higher rates, making it even harder for consumers to keep up their payments. They are often blamed for recent increases in the foreclosure rate.
"First, Freddie Mac will only buy subprime adjustable-rate mortgages (ARMs) -- and mortgage-related securities backed by these subprime loans -- that qualify borrowers at the fully-indexed and fully-amortizing rate," the company said in a statement. "The goal is to protect future borrowers from the payment shock that could occur when their adjustable rate mortgages increase."
Freddie Mac said it will also limit the use of low-documentation underwriting for these types of mortgages to help ensure that future borrowers have the income necessary to afford their homes.
In addition, Freddie Mac will strongly recommend that mortgage lenders collect escrow accounts for borrowers' taxes and insurance payments.
Consumer advocates reacted positively. Martin Eakes, CEO of the Center for Responsible Lending, said Freddie Mac was "leading the way toward better underwriting practices in the subprime market."
"Freddie Mac's announcement represents a major step toward ensuring that homeowners receive loans they will be able to repay. With home foreclosures rising in every region of the country, Freddie Mac's action could not be more timely," he said.
Other lenders are also cutting back on subprime loans, and with less subprime mortgage money in the pipeline, the real estate market is increasingly relying on borrowers who have well-documented income and enough cash to make a substantial down payment.
The effect is to shut lower-income consumers out of the housing market, thus driving down real estate prices even further. That's good news for higher-income buyers but bad news for sellers, and for those lower-income consumers hoping to get a toehold in home ownership.
Freddie Mac's Timetable
In keeping with its statutory responsibility to provide stability to the mortgage market, Freddie Mac said it will implement the new investment requirements for mortgages originated on or after September 1, 2007, to avoid market disruptions.
As an alternative for consumers with impaired credit, the company said it is also developing fixed-rate and hybrid ARM products that will provide lenders with more choices to offer subprime borrowers. For example, in contrast to the payment structures of many of today's "2/28" ARMs, Freddie Mac's new hybrid ARMs will limit payment shock by offering reduced adjustable rate margins; longer fixed-rate terms; and longer reset periods.
Freddie Mac will require originators to underwrite these products at the fully indexed and amortizing rate. The company plans to commit significant capital to purchasing these loans into its retained portfolio.
"Freddie Mac has long played a leading role in combating predatory lending and putting families into homes they can afford and keep," said Richard F. Syron, chairman and CEO of Freddie Mac. "The steps we are taking today will provide more protection to consumers and enhance the level of underwriting standards in the market."
Freddie Mac's new requirements cover what are commonly referred to as 2/28 and 3/27 hybrid ARMs, which currently comprise roughly three-quarters of the subprime market. Specifically, the company is requiring that borrowers applying for these products be underwritten at the fully-indexed and amortizing rate, as opposed to the initial "teaser" rate. The company also will limit the use of low-documentation products in combination with these loans.
For example, the company will no longer purchase "No Income, No Asset" documentation loans and will limit "Stated Income, Stated Assets" products to borrowers whose incomes derive from hard-to-verify sources, such as the self-employed and those in the "cash economy." There will be a reasonableness standard for stated incomes.
In addition, Freddie Mac will require that loans be underwritten to include taxes and insurance and will strongly recommend that the subprime industry collect escrows for taxes and insurance, as is the norm in the prime sector. Because the maintenance of escrow accounts requires significant infrastructure and is not widely used in the subprime sector, Freddie Mac does not believe it is practical to unilaterally mandate it as a purchase requirement at this time.
"Escrowing for taxes and insurance clearly provides an added layer of consumer protection," Syron said. "It is our hope that this universal practice in prime lending today becomes the universal practice in subprime lending tomorrow."
Freddie Mac is a stockholder-owned company established by Congress in 1970 to support homeownership and rental housing. It purchases residential mortgages and mortgage-related securities, which it finances primarily by issuing mortgage-related securities and debt instruments in the capital markets.