At Arm's Length - Financial Commentary about Money, Investing, and How It Affects the Average Investor

At Arm's Length: 04.18.05

Risky Business

Shortly after Alan Greenspan warned Congress about the size of the mortgage portfolios carried by Freddie Mac and Fannie Mae and the fact that they might hold an unwarranted risk for the government, it was revealed that the underlying health of those portfolios might be under question as well.

A broker, who sold mortgages to the agency, was found to have profited from the selling of high interest mortgages to high risk buyers only to turn around and offer them incentives to refinance. These mortgages were then sold to Freddie Mac, which is illegal while the lender kept the fees.

The mortgages showed up in 48 of 115,000 pools of securities held by the company totaling $178 million. While this is almost a non-news event, the broker will be found and prosecuted for manipulating the system, the underlying problem of finding a home in this high priced market and financing it in spite of poor qualifications has grown substantially in recent years. Finding such activity in Freddie Mac's portfolio should not come as a surprise though.

The number of foreclosures has risen as a result of these practices in recent years and the primary victims are in the investors in the secondary securities market.

It works like this: When a buyer purchases a home, the lender receives a fee. That loan is in turn sold on a secondary market to investors who purchase these securities for their guaranteed return and low risk. If the underlying securities have been created using fraudulent, fee generating means, it jeopardizes the whole basket of securities.

As the so-called bubble in the housing market increases, the risk of finding more of these lending practices will rise. Lenders seem focused on the fees, offering first and second mortgages to home buyers and then refinancing them again shortly there after. In a way, this practice has allowed the price of homes to inflate as competition for buyers reaches a lower, less creditworthy group of potential buyers.

If Congress doesn't step in quickly, this GSE, or government sponsored enterprise will create financial havoc with the housing market. Worse, it will come at a time when everyone is expecting the bubble to burst from rising interest rates and a slowing economy.

The previous week's articles.

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