While government sponsored enterprises (GSEs) Freddie Mac and Fannie Mae continue battling down the credit scale, non-GSE subprime lenders - seemingly in herds - are exiting the business.

At least a few sources have suggested that the threat of GSE penetration is another factor scaring lenders out of the subprime mortgage sector.

"Fannie Mae and Freddie Mac are about to skim the cream," one source said. "And that will leave the traditional subprime lenders with the weaker borrowers and the losses; this is called adverse selection'."

The argument is that, with a weaker borrower pool, non-GSE lenders hitting the B-and-down credits will be forced to charge even higher interest rates, if they wanted to cover their losses.

Lately, market exodus has been a much-talked about phenomenon in the asset-backed world, with banking and securitization giants like Advanta Corp. and First Union (by closing The Money Store) leaving the subprime mortgage industry.

"I don't know on those individual cases [what their incentives were]," said Wright Andrews, partner at Butera & Andrews, and Washington counsel for the National Home Equity Mortgage Association (NHEMA).

"But there is no question that industry executives are extremely concerned," said Andrews. "During the last couple of years, at NHEMA annual meetings... this was one of their overwhelming concerns, that the more the GSEs get in, the more devastating it would be to the market."

Though, for more than a year both GSEs have instituted programs which originate A-minus loans, the volumes - estimated to be less than $1 billion in 1999 - have not been high enough to really have an impact at this point, said Tom Zimmerman, head of asset-backed research at PaineWebber.

"I don't think it's really factored in yet," Zimmerman said. "It's like what they're doing is just dipping their toes in the water, trying to get the programs started."

However, he added, "It certainly has to have an impact on somebody's strategic thinking. Anybody thinking three or four years down the road has to be thinking about it, that these guys are trying to come into this market in a big way."

Pool Purity

Though industry competition is of concern, some argue - from an investor's point of view - an equally important issue is pool performance, and how it will be effected if large concentrations of A-minus loans are securitized in otherwise conforming pools.

One question that has yet to be answered is where the subprime loans would be placed, with regard to the securities issued. Currently, any Fannie or Freddie subprime loans have been issued alongside the conforming loans in the mortgage pools, according to market sources.

"Freddie Mac currently takes their A-minus loans - the ones that they do originate - and they just throw them into their Freddie Mac pools," an investor said.

For Fannie Mae, subprime loans with risk-adjusted basis points of 100 or less are placed in the same pools with conforming mortgages.

Because there is no disclosure as to the concentration of these loans (other than it must be less than 10%) when the pools are securitized, investors are likely to take issue, as the prepayment and defaults are likely to change.

"It's a real concern on the part of investors that Fannie and Freddie will dilute the purity of their current passthroughs," PaineWebber's Zimmerman said. "A lot of investors are going to be upset if they put a whole lot of A-minus loans into those deals."

Prepayment models that predict the performance of Freddie and Fannie securities lose value when there are undisclosed concentrations of non-conforming loans in the pool.

Currently, Fannie and Freddie are awaiting the decision HR3703, a bill that would tighten regulation over the GSEs, and make it more difficult for them to expand their product lines.

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