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Managing Risk in High LTV Loans
In addition to its usual recap of economicrnand housing indicators and future projections this week’s edition of FreddiernMac’s Insights and Outlook sought tornput any potential risk of its the new 97 percent mortgages in context. The mortgages, a program Freddie Mac callsrnHome Possible Advantage, were rolled out last spring and a similar program wasrnintroduced by Fannie Mae the previous autumn. </p
The new mortgages have safeguards to limitrnthe credit risks associated with the low down payments including solid FICOrnscores and require private mortgage insurance. rnA key element of the program is the elimination of layered risks; arncombination of multiple risky features has been found to magnify the total riskrnof a loan. It was layered risk thatrnpresented a significant vulnerability to loss in loans originated prior to thernGreat Recession.</p
Building on a quote from banker Walter Wriston,rn”Judgment comes from experience-and experience comes from bad judgment” thernarticle says it was some of the market’s bad judgments during the housingrnbubble that led to the losses experienced thereafter. Those events in turn give markets thernexperiences that forge better judgment behind the design of programs like thosernnow offered by Freddie and Fannie. </p
BeforernFreddie Mac launched the program it had to assess the magnitude of the risk ofrnlow down payments. To do this they lookedrnat loans funded by the company between the beginning of 2000 and June 2013 and calculatedrnthe actual losses realized between January 2003 and the end of the period, arnspan the includes both peak loan losses and a more typical pattern ofrnloss. They measured the absolute risk byrnthe average percentage loss on groups of loans but loss are dominated by therntime period i.e. absolute risk would be higher in periods of unusually high</bloss. Therefore Freddie Mac looked atrnrelative risk, the ratio of the absolute risk of two comparable groups. Forrnexample, 3/1 hybrid ARMS had an absolute risk 35 percent higher than that ofrn30-year fixed-rate mortgages (FRM), or an absolute risk ratio of 1.35. </p
Thernreport says that, not surprisingly, low down payment mortgages were found to bernrelatively riskier than loans with down payments between 20 and 29 percent butrnwhat was surprising how small the difference was. Loans with a 95 percent or higherrnloan-to-value (LTV) ratio were found to be only 31 percent riskier than loansrnwith an 80 percent LTV – in other words about as risky as a 3/1 ARM. Further, the relative risk of other types ofrnloans was much higher. Hybrid 7/1 ARMsrnwere 155 percent riskier than 30-year FRM and 5/1 ARMS carried five times thernrisk.</p
So clearlyrnone way to control the risk of low-down payment loans is to make that optionrnavailable only for fixed rate loans, avoiding the payment shocks that can leadrnto financial problems – and not layering on additional risk. When only FRM were analyzed Freddie Mac foundrn95+rnLTV loans were 68 percent riskier than 80 LTV loans. This estimate is a bitrnhigher than the 31 percent relative risk for all loan types but still muchrnlower than the relative risk of medium-term hybrid ARMs. And at exactly 97 LTV,rnthe maximum allowed by Home Possible Advantage, low down payment loans werernonly 17 percent riskier than 80 LTV loans.</p
Again quoting Wriston, “All life is thernmanagement of risk, not its elimination,” Freddie Mac’s economists concludedrnthat low down payments, by themselves, do not carry unreasonable credit riskrncompared to other well-accepted mortgage products. Thus one key to reducingrnrisk is to avoid layering on other components of risk.
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Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.
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