Crowding out in the nonconforming market?

Author:Morse, Neil J.
Position:Secondary Market - Fannie Mae, Freddie Mac

How will nonconforming lenders do when Fannie and Freddie move more aggressively into that market? What are the niche strategies that are helping these nimble, smaller companies survive?

FANNIE MAE AND FREDDIE MAC have similar effects on the mortgage industry as the sun does on the earth. These two government-sponsored enterprises (GSEs) can sustain life in the mortgage markets--and stifle it as well--just as the sun can with its varying degrees of solar energy. As the two secondary market companies continue buying more loans farther down the credit spectrum, some lenders praise the sunlight while others curse the heat.

So prominent are the two GSEs in mortgage finance that there is an exclusive word to describe the loans they buy: "conforming"--as in, meets their criteria for purchase. The best-known criterion is loan amount. Loans that exceed the current ceiling of $300,700 may not, by regulating statute, be purchased either by Fannie Mae or Freddie Mac. These days, that's the easy part of the "conforming" definition.

The hard part is knowing which loans the giant GSEs will buy below that dollar amount ceiling. In the last five years, Fannie Mae and Freddie Mac have developed more appetite for loans they previously eschewed. The greater hunger, driven by a need to maintain handsome shareholder profit, has stretched old meanings of conformity. Today, the two companies are increasingly buying loans formerly out of bounds that are either labeled subprime, nonprime or nonconforming, depending on the specific attributes of the loans.

The change has put smiles on some faces, but left others with fearful frowns.

"If they move into a certain part of the [nonconforming] niche without embracing all of it, that could make it more difficult for us," says Steve Mageres, vice president of capital markets for First Franklin Mortgage Co., San Jose, California. "It means we have to take on more risk."

As Mageres figures it, the widening scope of GSE loan buying provides the largest mortgage originators with an attractive, low-cost outlet for their A-minus, alternative-A and subprime loans, and further commodotizes the industry. "It changes the game for us," he says.

First Franklin, which expects to originate $7 billion in nonconforming loans this year, stands to encounter more competition on "just-miss" loans from industry giants like Wells Fargo Home Mortgage, Des Moines, Iowa, and Washington Mutual Inc., Seattle, which now can sell such paper to Fannie Mae and Freddie Mac. In turn, like water falling off a rock ledge, that means more competition among second-tier lenders forced to fish in waters with fewer--and less desirable--nonconforming borrowers. Mageres says that this would occur "as a function of who is good at size and scale vs. specialized credit underwriting"--meaning First Franklin. It's not a case of special negotiations between the GSEs and the giant originators, "but that doesn't hurt," says Mageres. "It's more of an automating of the process; a commoditization."

It also spells profit erosion, according to Richard Wohl, president and chief operating officer of IndyMac Bank Mortgage Banking Group, Pasadena, California. The GSEs, says Wohl, "will pick up part of the margin that used to go to us when we had the market all to ourselves." Combined, the GSEs bought about 6o percent of IndyMac's $16 billion loan production in 2001, a share likely to be matched this year, as the company originates about $19 billion.

Wohl says that that troubling prospect, however, is "more than outweighed by the positives"--like faster asset turn, greater market structure and more liquidity resulting from the GSEs' bigger footprint in the market. Parenthetically, Wohl says, "It also means a better price for consumers.

IndyMac started out as a niche lender approximately 10 years ago, making mostly alt-A and nonconforming loans and then securitizing those products in the secondary market, issuing mortgage-backed securities (MBS). Today, its biggest-selling products are conforming loans and alt-A. In the first quarter of 2002, conforming loans totaled a 26 percent share and alt-A totaled a 41 percent share.

The broker channel is its single biggest method of attracting loans. Wohl says the company does not have a retail sales force; instead, it interacts with borrowers through...

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