“THE UNITED STATES’ FANNIE MAE SAGA RAISES ITS HEAD AGAIN-

THIS TIME ITS EFFECT IS GLOBAL!”- March 2007

Keywords- United States's Depository Institution Management Interlock Act 2000;

European Union Directive 2002/87; Depository Institutions Deregulatory and Monetary Control Act 1980.

Several analysts agreed on Monday March 5th 2007, that New Century Financial Corp., one of the United States largest sub-prime mortgage lenders, may face liquidation or bankruptcy following revelations that it's under criminal investigation and in violation of debt covenants with several lenders. New Century, the second largest US subprime-mortgage lender[2] warns that it may breach lending covenants. The Securities and Exchange Commission is looking into New Century, as is the regulatory arm of the New York Stock Exchange. If New Century's lenders do not grant the requested waivers, the company is likely to be forced to sell or shut down. Indeed, New Century warned that if it can't get waivers or covenant amendments from enough of its financial backers, the company's auditor, KPMG, will conclude "that substantial doubt exists as to the company's ability to continue as a going concern." Companies like New Century that specialize in subprime loans have suffered as housing prices stopped rising and interest rates climbed from record lows.

Sub-prime mortgages are offered to homebuyers who fail to meet the strictest lending standards. Lenders specializing in such loan, rely on banks to finance their operations. Banks are called ‘warehouse lenders’, and require that sub-prime lenders meet certain minimum financial targets otherwise these banks have the right to end the business relationship.

Analysts at Stifel Nicolaus cut their ratings on shares of several mortgage lenders on Monday6th March as more bad news hit the troubled market of subprime mortgages.

Fremont General Corp. was also down-graded and its share price fell after the company said it plans to sell its sub-prime lending business after it received a proposed cease-and-desist order from the Federal Deposit Insurance Corporation. Meanwhile, HSBC Holdings announced a huge charge on bad loans in the sub-prime sector. After meetings with mortgage lenders HSBC are taking a significantly more bearish stance on the sub-prime mortgage industry and HSBC downgraded shares of Accredited Home Lenders and NovaStar Financial Inc.

The sub-prime mortgage industry is now in a downward slope and each negative development fuels additional deterioration in key fundamentals

Investors are nervous about the potential fallout in credit markets now that the housing bubble has burst and mortgage lenders are tightening their standards. US housing prices are now falling nationwide and there is evidence that the industry stressed underwriting too far.

PAST MORTGAGE COLLAPSES - THE SAVING AND BANKS DISASTER

It must be remembered that there was a mortgage market scandal in the US.; the Savings and Loans debacle[3] which caused billions of dollars of bank losses in 1989 Savings and Loans were small money lending co-operatives which grew in poor communities and gathered deposits from people in the neighborhood by paying interest on savings and lending the money to other neighbours who wanted to borrow money to buy homes. With government permission, this grew, but with rising inflation and fraud, deposits were spent and loans were taken out to pay loans until the system crashed and depositors lost their money when US federal debt rose to $2000 billion.

THE PRESENT MORTGAGE ISSUE

Now only 18 years later, it is happening again in the mortgage market. From a deficit of 542 billion US dollars in 2003, the US had a retained mortgage portfolio of $1000 billion plus debts to EU and Asian banks of $800 billion and a sharp increase of hedge funds to US $ 40 billion. The US also has $ 210 billion in credit card loans[4]. With US business mostly equity based, compared to the equity and fixed income business base of Europe, there is not much competition between banks. The Federal Bureau of Investigation (FBI) reports in 2004 state that the whole US mortgage market is fraudulent.[5] The FBI have investigated hundreds of mortgage frauds[6] recently covering billions of US dollars which are defrauded , causing billions of dollars of losses to financial institutions. Such mortgage fraud is occurring in Charlotte, Washington, New York, Georgia, Missouri, California, Nevada and many other states and is therefore widespread.[7]

The US with the Basel Committee, have developed specific rules for these 'thrifts' in the EU, such as the Joint Agency Statement on Parallel Banking Organisations ('thrifts') and the Office of Thrift Supervision (OTS) now has a role as a consolidated financial services regulator under European Union Directive 2002/87. [8] The United States now has joint legislation with the European Union, partly governing the EU banking sector.[9]. . The Bank of England Financial Stability Report 2004 revealed that the US accounts for the largest single country exposure of UK -owned banks. . US 'thrifts' have, over many years, let into the global financial system trillions of dollars of unregulated financial products, most of which can be summarised as 'junk bonds'. The EU and the US now wish to call an amnesty on and start afresh with new regulations to be applied only to new products. This is the crux of the European Union's Basel II Accord and the United States's Depository Institution Management Interlock Act 2000 (DIMIA). Cross-border financial interaction with some form of security via capital requirements for all banks and non-bank institutions are now in place.

US SubPrime Mortgage Market in March 2007

Accredited is one of the stronger independent subprime lenders[10], with high credit quality and a relatively strong balance sheet, according to analysts. Already, three subprime lenders have filed for bankruptcy – Résumé, Ownit Mortgage and Mortgage Network USA. At least three others are reportedly for sale, according to analysts, including Ameriquest's subprime unit and Fremont General and Option One.

Accredited and other lenders that specialize in mortgage loans for borrowers with blemished credit have faced a barrage of troubles lately. Rising borrower defaults have soured the appetite of investors who buy the subprime mortgages[11] on the secondary market, squeezing lenders' ability to make money selling the loans they originate.

Moreover, investors often require lenders to buy back loans if they default shortly after they're originated. That has further strained the liquidity of subprime lenders – many of whom are based in Southern California – as they're forced to boost reserves for defaults.

However, Fannie Mae sees little exposure to subprime loans which have been troubling the mortgage market and Fannie Mae expects little impact from new regulatory rules on so-called non-traditional mortgages since only 0.2 percent of the company's single-family "mortgage credit book" consisted of subprime loans at the end of 2006, Fannie Mae stated in its 12B-25 form with the SEC. At the end of 2006, roughly 2 percent of that same book of business involved mortgage-related securities backed by subprime loans issued by companies other than Fannie Mae or Freddie Mac.

The US Federal Reserve Board’s statement on the history of the subprime market

“One of the key financial developments of the 1990s was the emergence and rapid growth of subprime mortgage lending. Because of regulatory changes, the desire for increased profits, significant technological innovations, and liberalization in some government mortgage support programs, lending institutions began extending credit to millions of borrowers who previously would have been denied credit, both for mortgages and for other consumer loans. The increased availability of subprime mortgage credit has created new opportunities for homeownership and has allowed previously credit-constrained homeowners to borrow against the equity in their homes to meet a variety of needs. At the same time, increased subprime lending has been associated with higher levels of delinquency, foreclosure, and, in some cases, abusive lending practices

Subprime lending can be defined simply as lending that involves elevated credit risk. Whereas prime loans are typically made to borrowers who have a strong credit history and can demonstrate a capacity to repay their loans, subprime loans are typically made to borrowers who are perceived as deficient on either or both of these grounds. Obviously, lenders take a borrower's credit history into account when determining whether a loan is subprime; however, they also take into account the mortgage characteristics, such as loan-to-value ratio, or attributes of the property that cause the loan to carry elevated credit risk.

A borrower's credit history is usually summarized by a Fair Isaac and Company (FICO) credit score. Everything else being the same, borrowers with FICO scores below 620 are viewed as higher risk and generally ineligible for prime loans unless they make significant downpayments. But it is noteworthy that about half of subprime mortgage borrowers have FICO scores above this threshold, indicating that a good credit history alone does not guarantee prime status.

Compared with prime loans, subprime loans typically have higher loan-to-value ratios, reflecting the greater difficulty that subprime borrowers have in making downpayments and the propensity of these borrowers to extract equity during refinancing. They are also somewhat smaller in size. Whereas only about 1 percent of prime mortgages are in serious delinquency, the rate for serious delinquency on subprime is more than 7 percent. Not surprisingly, subprime mortgages also carry higher interest rates than those for prime loans. Evidence from surveys of mortgage lenders suggests that a weak credit history alone can add about 350 basis points to the loan rate.

The growth in subprime lending represents a natural evolution of credit markets. Two decades ago subprime borrowers would typically have been denied credit. But the 1980 Depository Institutions Deregulatory and Monetary Control Act eliminated all usury controls on first-lien mortgage rates, permitting lenders to charge higher rates of interest to borrowers who pose elevated credit risk, including those with weaker or less certain credit histories. This change encouraged further development and use of credit scoring and other technologies in the mortgage arena to better gauge risk and enabled lenders to price higher-risk borrowers rather than saying no altogether. Intense financial competition in the prime market, where mortgage lending was becoming a commodity business, encouraged lenders to enter this newer market to see if they could make a profit,”

Subprime Mortgages 2000-2003(Billions of US dollars)

Year	Subprime originations	Total originations	Subprime as a percent of total
2000	138.0	1,048.0	13.2
2001	173.0	2,100.0	8.2
2002	241.0	2,780.0	8.7
2003	332.0	3,760.0	8.8

Source: Mortgage Statistical Annual, March 2004.

Is this an indication of an ENRON about to occur again? Are there similarities in the mortgage market and the energy market which produced the embryo for the ENRON fiasco? What are the indications? In March 2007, the Chairman of the United States Federal Reserve urged Freddie Mac and Fannie Mae, the US mortgage refinances, to sell most of their combined $1,400 BILLION home loan investment portfolio. In March 2007 Barclays Bank revealed that it is carrying a $1 BILLION exposure to New Century Financial Corporation, a subprime lender. HSBC bank has admitted in March 2007 that it has bad debts of $10.6 billion relation to the subprime mortgage market. Finally the Wall Street Stock Exchange showed volatility in March 2007, which has triggered similar falls in global markets.

I return to Fannie Mae’s false accounting in 2004 and the US Savings and Loans Collapse in 1985. Fannie Mae was formed soon after the Savings and Loans collapse.

ENDS

Bibliography

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[1] Full Member of the Society of Legal Scholars, UK.

[2] A sub-prime lender is one who lends to borrowers who do not qualify for loans from mainstream lenders. Some are independent, but increasingly they are affiliates of mainstream lenders operating under different names.Sub-prime lenders seldom if ever identify themselves as such. The only clear clue is their price, higher than those quoted by mainstream lenders.

[3] O'Shea.J, (1991), 'The DAISY CHAIN - the sensational and true story of the greatest banking scam ever - the Savings and Loans scandal', London: Simon & Schuster.

[4] Bank of England, (2004), 'The Financial Stability Conjecture and Outlook Report', p.28.

[5] Fleishman. S, (2004), 'Mortgage fraud concerns FBI', Washington Post, 18 September 2004.

[6] US examples of mortgage fraud are (1) buying a house with a large mortgage at a greatly increased price from a partner, selling it back to him quickly for its real market price and leaving a large mortgage unpaid; (2) fictitious credit histories in order to obtain large mortgage; (3) forged loan documents; (4) mortgage foreclosure methods used to buy property in order to conceal the true buyer's name.

[7] Frieden. T, (2004), 'FBI warns of mortgage fraud 'epidemic'. Seeks to head off 'next S & L crisis', Washington :CNN Law Centre. By 2004 all these states which suffered mortgage fraud had enacted new and amended legislation to stop anti-predatory lending home loan practices.

[8] Croke. J .J and Manbeck. P. C, (2004), 'Revisions to Proposed Basel Capital Adequacy Framework', The Banking Law Journal, New York: A. S.Pratt & Sons.

[9] There is at present $1 trillion in the EU banking sector.

[10] Sub-prime lenders base their rates and fees on the same factors as prime lenders. For example, rates are higher the lower the credit score and the smaller the down-payment. However, the entire structure of rates and fees is higher at sub-prime lenders to cover the greater risk and higher costs of sub-prime lending. A higher percentage of sub-prime than of prime loans go into default. Sub-prime lending costs are also higher because more applications are rejected and marketing costs are higher. Among subprime loans that don’t default, a higher percentage prepay early. Prepayment penalty clauses are often mandatory, and a high percentage of subprime loans have them.

28s will often rise sharply at the 2-year mark, even if market rates do not change during the period. The major threat to such a plan is a prepayment penalty that runs past two years, which some do; and a lender who fails to report their payment history to the credit reporting agencies.