Fannie Mae, Freddie Mac Bought Flood of Refinancing Loans Pre-Crisis

The Government Sponsored Entities, or GSEs, responsible for buying mortgages and packaging them as mortgage-backed securities (MBSs) are well known to have been at the center of the subprime mortgage crisis.

The Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation, colloquially known as Fannie Mae and Freddie Mac, were accused of lowering their underwriting standards to encourage subprime lending.

As then-CEO Daniel Mudd would testify before Congress in 2007, Fannie Mae held high standards for their underwriting but would chase the market into subprime lending. Their exposure to subprime loans was only a meager 2.5 percent, yet FNME’s head of single family lending, Tom Lund, wondered if the company was “setting [borrowers] up for failure?" by enabling risky lending.

Much of Fannie Mae’s losses during the crisis came from exposure to Alt-A loans—a type of subprime loan that doesn’t require as much paperwork and were sometimes referred to as “liar loans.”

But Home Mortgage Disclosure Act (HDMA) data for the period shows that the vast number of loans purchased by the GSEs were refinance loans—loans to replace a pre-existing loan for the same borrower—not loans for new borrowers whose financial status was unknown.

The GSEs went from purchasing less than 1 million refinance loans in 2000 to almost ten times that amount in 2003. There would be 4 times as many refis as home purchase loans that year, driven by lower interest rates and policy changes that encouraged home equity lines of credit.

Additionally, there was no discernible change in the median income for borrowers of GSE-backed loans, and previous research has shown no discernible change in average credit score during the subprime crisis. Only after 2008 when the financial crisis was in full swing did underwriting standards increase and average credit scores rose as a result.

Lower Interest Rates

At the time, interest rates were dropping dramatically. The Federal Funds rate, which had been slowly dropping over the last few decades, plummeted from 6.51 percent in 2000 to 1.75 percent in 2002, the lowest it had been since the early 60s.

As interest rates dropped, refinance loans applications flooded in, while home purchase loans remained relatively constant.

As interest rates spiked starting in 2004, the housing market would crash leading to the financial crisis of 2007-2008.

Banks, Insurers, and Others Start Buying

As refinance loans were the main component of the flood of loans from 2000 to 2003, the vast majority were bought by the GSEs, who were the de facto purchaser of most mortgages at the time.

Private purchasers—banks, mortgage companies, or insurance companies—were minor players in the world of mortgage underwriting at that point, but they were a growing segment.

After 2003, the GSE’s buying stopped dramatically. Private purchasers, or private-label securitization (PLS), stepped in. While providing a similar service, they didn’t provide the same regulated standards of underwriting as the GSEs.

Private entities would purchase over 5 million loans in 2005, about the same amount purchased by the GSEs in 2000 as interest rates started increasing.

Encouraging Reverse Mortgages

Besides cheap interest rates at the time, elderly borrowers were encouraged to refinance and lean on home equity lines of credit, sometimes called reverse mortgages, to help pay bills, make renovations, and stay in their homes.

The American Homeownership and Economic Opportunity Act of 2000 would make the process of obtaining a reverse mortgage easier, allow co-ops to get those loans, and help bypass loan insurance payments for certain borrowers.

Reverse mortgages would become another linchpin of the subprime mortgage crisis. Lenders of jumbo reverse mortgages like Indymac and Lehman Brothers would suffer as interest rates increased, spurring the downturn in the market.