Freddie Mac has launched a major subprime mortgage program by purchasing and guaranteeing $227 million of loans originated by a unit of First Union Corp.
Under the new program, Freddie Mac's guarantee, which gives mortgage securities a triple-A rating, will be applied to as many as 40,000 subprime mortgages this year. The deal last week with First Union marked the government sponsored enterprise's first significant foray into a line of business that it has tiptoed around for the past year.
Freddie Mac's direct participation in the subprime business could bring down interest rates and give more mainstream lenders the chance to share in a market that has traditionally been the domain of finance companies.
"We believe we can bring a lot of benefits to the market" by making lending to people with blemished credit safer and more appealing, said James Cotton, Freddie Mac's vice president for marketing.
But the program could also become a flashpoint in a continuing debate over whether Freddie Mac and Fannie Mae should give up their charters and operate more like private companies. Some subprime lenders said they will lobby Congress to prevent Freddie Mac from unfairly grabbing business by using its lower borrowing costs and implied government guarantee.
Freddie Mac is "getting into a business that clearly seems to be out of their mandate," said Hugh Miller, chairman of Delta Funding, a subprime lender in Woodbury, N.Y. "Perhaps Congress should consider whether these companies should be privatized, to level the playing field."
A staff member for House Banking Committee Chairman James Leach, R-Iowa, said the committee will look into the First Union and subsequent subprime deals.
Rep. Leach has taken a leery view of efforts by Freddie Mac and Fannie Mae, as government sponsored agencies, to branch beyond their charters and perhaps benefit from their implied government backing.
Freddie Mac began the initiative last week by purchasing subprime and conventional home equity loans originated by First Union Bank. In coming months, Freddie Mac expects to support several more subprime securitizations, through First Union and other lenders.
Overall securitizations by Freddie Mac this year could reach about $2.5 billion, based on anticipated loan volume. That figure tops annual volume at all but the two biggest finance companies - Money Store and Contifinancial Corp.
Mr. Cotton said this year's volume is viewed as a test, with Freddie Mac trying out different structures, such as over collateralization requirements, and shying away from the riskiest credits to protect itself from losses. In guaranteeing loans, Freddie Mac agrees to pay investors' principal if their mortgage securities default.
Freddie Mac's goal is to generate more revenues through guarantee fees while meeting its mission of helping more people buy homes, Mr. Cotton said. "This could improve access to financing for low- and moderate-income borrowers" who typically cannot qualify for a conventional mortgage but can receive subprime loans.
In testing the waters, Freddie Mac obtained a letter from the Department of Housing and Urban Development that indicates transactions like the First Union deal are within Freddie's charter of fostering programs for low and moderate income borrowers.
Still, whatever inroads Freddie Mac makes will come at a cost to finance companies that have profited by charging higher interest rates on subprime loans, and insurance companies that have traditionally guaranteed the loans.
Finance companies would be unable to continue charging double digit interest rates if subprime mortgages became more like commodities, a very real possibility if Freddie Mac gets deeply involved with the market, said Peter Rubinstein, senior vice president of mortgage research at PaineWebber Inc.
"Freddie's guarantee will make these securities much more liquid, easier to trade, and ultimately bring down borrowers' costs," Mr. Rubenstein said.
Freddie's direct involvement in the subprime market follows months of working on the periphery, developing systems for lenders and ratings agencies to use to evaluate these loans. The closest Freddie Mac has come before now was a move last year to guarantee a pool of mortgages that defaulted before returning to performing status.
Rival Fannie Mae has also developed underwriting and other systems for subprime mortgages, and even guaranteed a loan package for subprime lender Advanta Corp., in November 1995. Fannie Mae ended up ahead on that deal, said spokesman Gene Eiseman. "We haven't paid out a cent" because of defaults.
Still, Fannie Mae does not have plans to directly guarantee more subprime loans, Mr. Eisman said. "Our philosophy is to use technology and better underwriting to qualify more people for prime mortgages, rather than being involved with subprime loans."
