Freddie Mac - we'll only buy almost anything

By now I'm sure you've read a hundred articles about the the Shanghai panic that led to a world-wide sell off of equities so I'm not going to add to the pile. My friend over at Shenandoah Capital has a good article that summarises what led to the carnage of the last 24 hours. More specifically I think what happened in Shanghai and the reverberations it caused are a sideshow to the main event yet to unfold.

MarketWatch.com carried an interesting article today on Freddie Mac getting tough on subprime mortagage standards. Freddie Mac shouldn't be confused with a bank or other financial institution that lend to potential homeowners. They actually buy mortgages and then sell bonds and other securites backed by those mortgages. You may know this process as securitization. They make money off the differential between the bond rate and the purchased loan, e.g. they buy a loan with a 5.25% interest rate put it in a mortgage backed security with a coupon of 5% effectively pocketing the 0.25% differential. OK, so what does Freddie Mac mean when they say they are getting tough on subprime mortgage standards?

Firstly what is a subprime mortgage? Basically its a high risk loan. Subprime mortgages are aimed at those who don't qualify for loans at mainstream financial institutions, although increasingly subprime lenders are just affiliates of mainstream lenders operating under different names. Generally they operate the same as prime mortgages but only with a higher interest rate to compensate for the higher risk.

Now that's great for those who have a hard time demonstrating to a bank they have the requisite amount of assets such as those whose livelihood is cash based or who run their own business. However think of the logic behind it for a minute. Someone who couldn't qualify for a loan at a mainstream institution because they are deemed too high a risk qualify at the institution's affiliate at an even higer rate and therefore even higher risk.

In the article Freddie Mac said they will:

"limit the use of loans that don't require income verification or other documentation."

So basically you can get a loan without having to verify your income level or assets, what the f...? Freddie Mac has been purchasing and selling loans that don't require proof that the borrower can pay them back and remember they are not going to stop doing this they are just going to limit them to those customers that are fully underwritten at the full borrowing rate not a discounted 'teaser' rate. That doesn't guarantee that the customer won't default it just excludes the riskiest customers. Further on in the article..

"In addition, the company won't purchase "no income, no asset" documentation loans and will limit so-called "stated income, stated assets"

What this all means is that Freddie Mac has gone from buying anything to almost anything. Senator Christopher Dodd of the Senate Banking Committee labelled Freddie Mac's move as:

"a responsible standard that ensures that these borrowers will have the ability to repay their loans, thereby protecting their home equity," "This is the right thing to do both for the borrowers and for Freddie Mac."

I think the senator is overstating it a little, I'm not so convinced.

Sure Freddie Mac is making an effort but look at what we're talking about here. Lenders have become that greedy they will lend to people who they don't even know can pay back the loan. So what, that's the environment of easy credit we live in these days you might say. Well I'd say something is wrong. Below is one of my favourite charts of late posted here without permisson from the Contrary Investor Read the whole article in the link above and tell me if you think everything looks rosy on the US home ownership front.