Moves by Fannie Mae and Freddie Mac toward buying loans of A-minus and lower credit quality are worrying lenders because of already tight profit margins in the subprime market.

This was a major topic of hallway conversation and panel sessions at the annual secondary-market conference here sponsored by the Western League of Savings Institutions.

But mortgage bankers were also saying that automated underwriting and risk-based pricing may soon bring more precision to credit risk evaluation and loan pricing in the conforming and jumbo markets.

As privately held corporations, Fannie and Freddie naturally want to expand their business to gain better profits. And both enterprises are pursuing A-minus loans, though with different tactics and nuances.

"It's a great opportunity for them," said Christopher D. Goode, senior vice president and director of secondary marketing at Home Savings of America, Irwindale, Calif., the flagship subsidiary of H.F. Ahmanson & Co. "It is the next frontier."

Though Fannie and Freddie want to expand their business by getting into more markets, however, "it remains to be seen what their real plan is," said Gary J. Westphal, group vice president, trading for capital markets at Norwest Mortgage Inc., Des Moines.

Echoing a presentation here by Patrick M. Sheehy, executive vice president for institutional lending at Norwest, Mr. Westphal said he shares concerns about automated underwriting tools. "We would like the ability to choose what tool we use," he said. And Mr. Westphal said he would like to have a generic product that could be delivered to multiple investors.

"Some of the investors are willing to buy the paper and not necessarily have it in Fannie, Freddie form," he said.

A whole-loan market for A-minus paper exists with investors, and these loans can also be packaged into private-label securities, Mr. Westphal said. Fannie and Freddie could provide another outlet for A-minus paper.

"If Fannie or Freddie approach that market, it may just be another outlet for that nontraditional paper, that nontraditional borrower," he said. But Mr. Westphal also asked, "Does this fit within Fannie's or Freddie's charter, or doesn't it?"

"We are redefining what A quality is," said Bill Shirreffs, director of single-family business at Fannie Mae's western regional office, during a conference session about working with conduits. "We don't perceive that we're taking on more risk. We're just redefining what A paper is."

Freddie Mac is also testing the waters in the subprime market. "We are treating our entree into the B and C market as a pilot," said Connie Ferran, director of implementation marketing at Freddie Mac. Freddie will later decide whether to buy these loans in large batches, she said.

Fannie's and Freddie's forays into lower-quality loan markets could lead to more favorable prices for consumers and tighter margins for lenders. "Efficient markets aren't necessarily good for business," said Peter T. Paul, president of Headlands Mortgage Co., Larkspur, Calif. "No spread is no fun."

Freddie Mac is offering alternative-A and A-minus loans to lenders in pilots and expects to expand this practice over time. A-minus loans are about 50% of the subprime market, Faith A. Schwartz, director of national alternative markets at Freddie Mac, told a session on originating the hottest loans.

"We will over time enter further into the subprime market," she said. Freddie Mac has two initiatives in its subprime efforts now. It is already offering risk-based pricing for alternative-A and A-minus loans on a loan- by-loan basis for a handful of lenders, Ms. Schwartz said. In addition, it is trying to learn about the market through credit-enhanced structured transactions in a "slow and prudent" way, she said.

Freddie Mac is using its automated underwriting program and risk-based pricing to price the credit risk associated with A-minus loans, she added.

Asked whether entering the subprime market was consistent with the charter of the government-sponsored enterprises, Ms. Schwartz said, "We think it's completely consistent to enter and serve these markets."

Ms. Schwartz noted that the subprime market has a higher percentage of minority group members, particularly African-Americans and Hispanics. In addition, she said, about 20% of borrowers in the subprime market are misclassified and would qualify for credit in the conforming market.

"Our feeling of reaching out to these markets is heavily dependent on our automated tools," Ms. Schwartz added.

Secondary-market managers said a very strong market is developing for A- minus paper. And sources at the conference said that investors, including major western banks, insurance companies, and thrifts, were looking for products that offer a slightly higher yield without compromising credit quality.

"Investors are going to broaden their lending terms to allow purchases for A-minus paper," said William J. Denton, vice president of secondary marketing at PNC Mortgage. And they will do it because it will pay higher yields and offer a means to manage loan runoff, he said.

"Freddie Mac is really leading the way here," Mr. Denton said. "Automated underwriting is going to facilitate this." PNC Mortgage uses Freddie Mac's automated underwriting program because of its cost- effectiveness and plans to apply it to jumbo loans, he said.

In the jumbo market there is already a pathway for loans to go from the customer to the investor without Fannie and Freddie playing a role, Mr. Denton said, and some of the major conduits are already doing risk-based pricing with these loans.

When Fannie and Freddie set up efficiencies for a new product, it "allows us to more quickly implement a product to serve the customer," said Mr. Goode of Home Savings. But there is also a downside.

"The more efficiencies they bring, the more it accelerates a competitive market," leading to smaller profit margins, he said.

Home Savings originates alternative-A loans and nonagency product that is A quality but has yet to enter the A-minus arena, Mr. Goode said. He said he looks at three criteria-volume, profitability, and ease of implementation-when looking into new areas of business.

Secondary-market directors at the conference noted that mass-market players were looking to Fannie and Freddie to provide both a product and a process for A-minus loans.

Larger players prefer A loans because they form a $1 trillion market. But Fannie and Freddie may facilitate A lenders' entrance into the estimated $100 billion B and C market through their underwriting technologies.

Risk-based pricing, introduced by Fannie and Freddie, is "absolutely the biggest change that is coming to the A market," said Mr. Denton of PNC.

PNC does not originate A-minus loans now but is planning to do so, Mr. Denton said. PNC does not originate B and C paper, because of the relatively small volume and because investors don't want it, he said.

Risk-based pricing is based on credit profiles and property-value profiles and will lead to price variations based on the resulting risk profile for A paper, Mr. Denton said. He predicted "an evolution" during the next five years that may lead to very specific rules for the A market. "We're moving down a path toward a closer relationship with the agencies," he said.

On the conforming side of loans, most lenders have been using a form of automated underwriting, but many are now considering it for jumbo loans and applying risk-based pricing to both types of loans. Secondary-market managers "need to start looking for proactive participation with agencies or with their own information technology people" in order to address these changes, Mr. Denton said.

Ultimately, expanding the private-investor market and the agency- investor market for A-minus paper will benefit the consumer with better pricing than for B and C loans, Mr. Denton said.

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