Fannie and Freddie to the Rescue?

New Territory for Fannie and Freddie

The agreement gives Freddie and Fannie access for the first time ever to the jumbo loan market. (Jumbo loans are defined as loans above the $417,000 limit on so-called conforming loans.) Currently, jumbo loans are restricted to private lenders. That means borrowers in high-cost areas -- such as Pelosi's home district in San Francisco, where the median price of a home is $825,400 -- have limited financing options. "Here in Massachusetts, $500,000 and $600,000 homes, which are above the limit now, are not luxury homes," House Financial Services Chairman Barney Frank (D-Mass.) recently told CNBC.

In their haste, policymakers left some important details unresolved. Democrats say the plan lifts the companies' loan caps to $729,750 in high-cost areas for one year, while Administration officials say the cap will be $625,000 through Dec. 31. Both sides agreed to permanently increase the cap on Federal Housing Administration (FHA) loans in expensive markets to $729,750.

Although Fannie and Freddie have dabbled with riskier loans in recent years, their bread and butter is backing conventional loans to borrowers with good credit and packaging those loans into securities for other investors. Their securitization business has largely kept that segment from seizing up along with the rest of the industry.

The Troubled Jumbo Loan Market

Lawmakers are hoping the companies can do the same for jumbo mortgages. Right now, no one wants to buy securities backed by the oversize loans. "It's almost impossible" to sell a jumbo mortgage, says Jim McKillop, president and CEO of Independent Bankers Bank of Florida, which helps smaller community banks in Florida, Georgia, and Alabama sell their loans to investors. Demand for securities backed by jumbo mortgages dropped dramatically beginning in the summer of 2007. The volume for new jumbo mortgage securities was cut in half, from $124.5 billion in the second quarter to $62.5 billion in the third, according to data from Inside Mortgage Finance.

Few banks are approving bigger loans and, when they do, the interest rates generally run 0.75 to 1 percentage point higher than for loans under $417,000. That has compounded the foreclosure problem in high-cost areas such as Los Angeles, where home sales have slowed to a crawl and the median price for a single-family home is $588,400, according to the National Association of Realtors. The banks still making jumbo loans can't sell them, and smaller institutions aren't equipped to manage the extra risk of holding them on their books.

Allowing Fannie and Freddie into the jumbo market should help off-load some of that risk for banks, free up credit for borrowers, and with any luck, slow foreclosure rates and stimulate sales in high-cost housing markets. Raising Fannie's and Freddie's loan limits should allow more borrowers in high-cost areas to refinance.

Not Without Its Own Risks

But not everyone is as optimistic as policymakers. Like the rest of the industry, the companies are struggling to manage their own balance sheets as foreclosures and delinquencies steadily rise. Jumbo loans carry more risk than conventional loans and are heavily concentrated in a handful of states. Loans from California alone accounted for nearly half of the market for jumbo securities during the first half of 2007. "Of course, many of the jumbo loans are in places where house prices are falling, so there are collateral risks in those areas," says Douglas Duncan, chief economist for the Mortgage Bankers Assn.

OFHEO also will have a say. Director James Lockhart opposes raising their loan caps without additional oversight. "We just don't think it would be good to divert resources and manpower of these two firms from doing what they do best, which is supporting the conforming loan market," Lockhart told BusinessWeek in a recent interview. "They've never bought jumbo loans. They don't have pricing models, they don't have risk management models. So it would be a new world."

Duncan estimates it will take Fannie and Freddie at least three to six months to assess the new risk and ramp up their systems to process jumbo mortgages. To offset that risk, Fannie and Freddie will have to charge higher fees for jumbo loans. So the interest rates won't be much better than today's pricing, according to Duncan and a separate analysis by OFHEO.

The companies are also hamstrung by a regulatory order that keeps a tight leash on their operations, requires extra capital, and limits their growth. "While Freddie Mac will continue to do what it can to assist borrowers and help restore liquidity to the market, this additional responsibility would create a significant challenge for Freddie Mac as we continue to operate under severe capital constraints," said Freddie Mac spokesperson Sharon McHale.