Fannie Mae's announcement of a new program designed to allow homeowners with less-than-perfect credit histories to be approved for mortgages rankled many mortgage players last week, reflecting a growing opposition to the agency's long-standing plans to enter the subprime arena.

Fannie Mae's Timely Payment Rewards program, designed to expand the size of the underwriting box it uses to qualify buyers, will give homebuyers in subprime mortgage markets the ability to borrow at a rate as much as two percentage points lower than the traditional rate for high-risk borrowers.

After 24 consecutive months of on-time payments, the borrowers would then qualify for a one percentage point reduction in the credit premium. The new program is being implemented through 20 or so Fannie Mae lenders, including some of the largest mortgage originators in the country.

However, this new plan is leaving many sell-side and buy-side players with some serious criticisms. Because these loans would eventually begin to appear in TBA securities pools, they could increase the risk of loan defaults and prepayments, which will hinder the ability to predict the securities' yields.

"I think this is a terrible thing," said one Wall Street observer. "The wide acceptance of the passthrough market, its liquidity, its huge number of committed and occasional players alike are all owed fundamentally at bottom that we are able to understand, model and somewhat control the risk regarding prepayments. The comfort level with prepayments is threatened when they start changing the collateral."

"Though on a passthrough it won't make a big difference," said another MBS Wall Street source, "when you leverage it into IO's, PO's, super-PO's and inverse-IO's, it begins to increase the level of uncertainty, and from our perspective, that is not a good thing."

Fannie Strikes Back

But loans originated through this program would not be much different than conventional loans, said Frank Demarais, Fannie Mae's vice president for product development. "These are loans that we feel comfortable that the conforming conventional market can originate, process and service within the parameters of the traditional conforming markets," he said.

However, there have been talks between Fannie Mae and the Bond Market Association to limit the amount of Timely Payment Reward loans to no more than 10% of TBA pools. This would reduce the uncertainty in those pools. Eventually, Demarais noted, Fannie Mae would be able to create separate securities with the loans, which would be included in an MBS where the loans would support the MBS passthrough rate.

While there is a risk of prepayments, Demarais said that he believes that refinances would be low. "The borrower gets a reward, 100 basis points reduction, which brings the rate back down to the conforming conventional rate and it reduces the incentives for the consumer to refinance simply because their credit improves," he said.

"I think this is an important initiative by Fannie Mae, and it is a logical extension of Fannie's long-lived effort to broaden the A-grade mortgage loan market," said Michael Youngblood, managing director of real estate capital markets at Banc of America Securities. "This will surely reinforce Fannie's important support of affordable housing."

Bond Market Association Steps In

Still, this program has been unsettling to mortgage players, given that the inclusion of these loans in MBS pools could cause their values to fluctuate.

Even though the program will take many months, even years, to reach its full potential, the magnitude of its possible impact is sizeable, and is expected to raise a great deal of comment from the industry, said Tom Zimmerman, a home equity loan and high LTV specialist at PaineWebber.

"If traditional mortgage lenders take a sizeable share of the A-minus sector, and traditional subprime lenders are left with fewer loans, and riskier ones, at that, on average it seems almost certain that subprime lenders will be forced to increase the rates they charge remaining B&C borrowers," Zimmerman said.

Thus, in an attempt to improve the opportunities for some lower income and minority buyers, Congress, which is viewed as the driving force behind the latest initiative, may be making it more difficult and costly for borrowers in the worst financial position, critics said.

Though the Bond Market Association has had some preliminary discussions with Fannie Mae on the issue, there have not been any formal discussions as of yet. According to George Miller, deputy general counsel for the Association, Fannie Mae is open to a dialogue on the matter but his organization has only just begun to gather information on the subject.

"A significant concern we have is that this kind of program could threaten the integrity and viability of the larger mortgage market," Miller said. "But we're still learning what Fannie Mae has in mind, both in terms of the origination program itself and their plans to securitize. If we include these loans in standard TBA deliveries, there will be a problem with prepayment analysis, because you taint the homogeneity of the TBA pools."

Most market participants agree that the materials released thus far by Fannie Mae do not clearly define the scope of the initiative. Among the factors that observers are waiting to find out more about is the minimum level of FICO score that Fannie Mae will accept under the new program.

"There is relatively little difference in the prepayment default behavior of a loan of 700 FICO versus one with 720 FICO," said Youngblood. "But there is a significant difference between 650 and 720. But before one is duly alarmed by the significance of Fannie Mae's initiative, one needs to know the scope of the program."

Fannie Mae's Demarais does not foresee any large problems in terms of value. "We'll be working with the investment interest and investment community on the appropriate approach to these loans and securities and we feel that we will always have the best interest of the MBS holders in mind," said Demarais, noting that no loans have yet been originated.

But some observers just don't buy it. "This is just disingenuous to say this 10% doesn't change the prepayment characteristics of collateral," said a Wall Street source who chose to remain anonymous. "But given the politics of this market and the weight of these entities, their power is lobbying, they have organizations in Congress and so forth. That housing capital is already available for these borrowers, and we don't need Fannie Mae or Freddie Mac to do it, especially since, over time, they crowd out truly private players.

"Perhaps it makes that A-minus loan a little cheaper, but it doesn't make it that much cheaper, because they charge more for it."

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