Amid widespread criticism coming from all directions, the undisputed heavyweights of the American mortgage industry, Fannie Mae and Freddie Mac, may have added fuel to the fire last week when officials from the GSEs told a congressional panel that they have every intention of creeping down the credit curve and tackling the subprime mortgage market.

Despite being under fire from politicians, academics, Street competitors and private-sector lenders for allegedly wielding too much influence in the mortgage market and straying from their original charter - to create and encourage a secondary mortgage market and facilitate every American's dream of buying a home - the two agencies asserted, to the dismay of many Street observers, that subprime is fair game.

"Making loans to people with less-than-perfect credit is not only totally within our charter, it is something we should do and something that is right to do," said Fannie Mae chief financial officer Timothy Howard.

Leland Brendsel, the chairman and chief executive of Freddie Mac, argued that the dispute between subprime lenders and the GSEs is simply over competition. If Freddie is being accused of trying to find ways to qualify subprime borrowers for lower-cost loans, "we plead guilty," Brendsel said.

The problem is that the GSEs' implied governmental backing and guarantees give them an unfair advantage over other private lenders, critics say.

"Because of their funding advantage, the GSEs will take away the better credit and put others at a disadvantage," said a ratings agency analyst who wished to remain anonymous. "Then, the private lenders will have to price those remaining loans even higher. After the agencies take the better-credit-quality obligors, that puts the lenders who have been in the market with the weaker obligors."

If the GSEs get business from A and A-minus borrowers, for instance, there will be a higher percentage of C and D obligors left over, who have a much higher probability for default.

"The other lenders would not be competing on a level playing field," the analyst added. "If the GSEs have a zero cost of funds and someone else has a 6% cost of funds, then they would be at a huge disadvantage."

"If they take out the top part of the A-minus [loan] market it will impact pricing, without a doubt," said a Street researcher. "The GSEs will take volume out of the market, especially a large chunk of the A-minus market."

But don't the agencies, who have a quasi-private status and stockholders to answer to, have the right to compete? Spokesmen from each of the agencies reiterate that the agencies offer a lower cost of financing than other lenders, which is a clear benefit to the borrower, and according to the agencies, a perfect fit within the agencies' historic charters.

"We are in the business of financing mortgages where we can appropriately price the credit and provide liquidity to the market," said Douglas Robinson, a Freddie Mac spokesman. "We don't buy mortgages based on how fast the grass grows in Indiana. We understand the credit; we know more about understanding credit. Our servicers know about servicing. We're now able to serve hundreds of thousands of borrowers who couldn't get a lower cost of financing. What we're doing is simply providing a better bid for the asset."

Moreover, Fannie Mae insists that their subprime borrowers can actually qualify for an A credit, but have impaired loans, and the GSE is simply "helping lenders reach these borrowers."

"Part of our mission is to help people achieve homeownership by offering conventional financing, which saves consumers money," said Alfred King, a spokesman for Fannie Mae. "These are borrowers who are not being as well served by the system as they can be, so we are reducing the cost for these borrowers. And along with our so-called funding advantages' come heavy obligations and restrictions on the types of businesses we can get into."

"If the rating agencies happen to give us a better rating then Lehman or RFC, or some other master servicer, then that is just another gradation in the marketplace," Robinson added. "If our servicer is better, then that's just how the marketplace works."

Diluting MBS?

Another thorny aspect of the controversy drawing attention is the fact that non-conforming loans have ended up in Fannie and Freddie pools without anybody knowing about it.

One market player familiar with Fannie Mae's original subprime guidelines said that if some Fannie-approved lender originated a loan that required more than 100 basis points of protection, it was put into a separate category; if it was less than 100 basis points, the GSE would put it into deals.

"And we wouldn't know about it. Many of the critics do not necessarily have a problem with the agencies going into subprime, but only with the fact that they are destroying the homogeneity of the MBS passthrough market," the researcher said. "For instance, there are many Alternative-A loans in MBS pools, but no way to distinguish them. And everybody knows those loans behave very differently than regular product."

"The agency MBS buyers are worried that subprime is going to dilute the purity of historic Fannie/Freddie product," said another MBS observer from a leading mortgage lending company. "The quality of the pools continue to deteriorate, and it's a winnowing process where better borrowers get taken out by the GSEs, forcing rates and profit margins down."

Additionally, the GSEs buy securitized product for their own portfolios. In a typical subprime deal, there is a conforming class and a non-conforming class. The conforming class goes into Freddie and Fannies' portfolio, and the rest of the deal goes into a separate portfolio.

"At least we think it does; it's not entirely clear," said the Street source. "Does the non-conforming portion go into separate deals? Do they have separate suffixes?"

"Perhaps they will create a subprime TBA market," he suggested.

The subprime initiative:

no success...yet

According to a transcript of the speech made last week, Howard also told the House Financial Services GSE subcommittee that automated underwriting systems are making it easier to offer subprime loans, but Fannie Mae has not been successful in marketing those loans to subprime borrowers.

The GSEs would not divulge the exact dollar amount of their current subprime business, but according to Street observers, the agencies have had significant difficulty making headway into the sector.

Originally, Freddie and Fannie took two different approaches to their venture into subprime territory: Freddie decided that the best way to understand the market is to wrap deals, while Fannie believed that more lenient underwriting guidelines was the key. There were at least 20 home-equity deals wrapped by FHLMC last year, sources said.

"It is clear that Fannie and Freddie have not made enormous inroads into subprime, although they're trying to," said a subprime analyst. "Fannie's idea, originally, was to open up their underwriting guidelines, bypass traditional subprime lenders and go to traditional lenders, incorporating that product in there. But they're not persuading people to do that."

Fannie's subprime volume was less than $1 billion last year - nothing to write home about. "The GSEs are realizing that it is more difficult to deal with an A-minus loan than an A loan," the analyst said. "That's the reason a bank like Fleet is doing A lending. If the agencies think they can treat an A-minus loan with the same servicing and same collection as an A loan, they will see that it doesn't work. They are learning that they can't charge that low rate."

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