The remainder of this paper examines the aspects of Freddie Mac's and Fannie Mae's procedures and policies that might inhibit the sale of "community" loans to the secondary market. For purposes of this discussion, I have organized the various into three broad categories: the wholesale nature of the secondary mortgage market; the economic disincentives that are associated with smaller loans; and the specific underwriting guidelines that have been adopted by Fannie Mae and Freddie Mac. The discussion primarily refers to investment-quality loans, that is, loans whose expected performance is relatively good. However, these same basic factors will also affect the types of riskier loans that are typically handled through special programs.

By all accounts, the typical community loan involves a greater amount of judgment on the part of the mortgage underwriter in order to assess its inherent risk. As described in more detail below, many otherwise creditworthy mortgage applications may have certain characteristics that tend to distinguish them from what are commonly known as "plain vaniha" loans-that is, loans that precisely meet the prototypical underwriting guidelines established by Freddie Mac and Fannie Mae in their Seller and Servicer Guides and adopted by a large proportion of the mortgage industry. While careful scrutiny of the borrower and the property may, in fact, reveal that the mortgage involves only the "normal" amount of risk. such scrutiny takes time and, in most instances, thorough familiarity with local markets, neighborhoods and customs.

By its very nature, this type of boutique mortgage underwriting is difficult to adapt to the highly centralized, large-scale operations that currently characterize the secondary market. When a lender sells a mortgage pool to Freddie Mac or Fannie Mae, the lender must certify that all of the loans meet the underwriting guidelines established by the purchasing agency. Individual loans are not reviewed prior to the actual purchase or otherwise pre-approved for sale. Instead, a small sample of a seller's product is selected for periodic, post-sale quality control audits. If Fannie Mae or Freddie Mac underwriters subsequently determine that a loan is out of conformance - that is, that certain underwriting guidelines have not been followed-the lender may be forced to buy back the mortgage. This can have serious consequences, particularly for nonportfolio lenders. Not only does a repurchase affect the lender's cash flow and asset position, it may also affect the lender's continued ability to find a ready outlet for its loans.

This problem is compounded by the fact that the underwriting standards are designed as guidelines, not absolute rules. Lenders are encouraged to use their judgment and to document reasons for apparent exceptions to established criteria. In the end, however, underwriting is an art, and not a science. Since opinions of reasonable people differ, so too can judgments about the amount of risk involved with a particular borrower or property. As a result, due to the uncertainties involved, many lenders may tend to play it safe, avoiding marginal or complex loans in order to minimize the likelihood of a forced repurchase.

These disincentives are further strengthened by the fact that community loans tend to be small, and that smaller loans are inherently less profitable to all those involved in the origination, sale and servicing of mortgages. For example, loan officers' compensation is typically tied to the value of the loans they make. Lower fees, combined with the fact that community loans tend to involve more processing time - in large part because of the documentation that is required to support deviations from standard underwriting guidelines - create a financial incentive in favor of larger loans.

These incentives toward larger loans ripple all the way up to the point of the mortgage's sale. In general, the cost of assembling, processing and documenting a mortgage pool for sale depends more on the number of mortgages involved than on their aggregate value. Thus, for equal-sized pools, those composed of a larger number of very small mortgages are more costly to assemble than those containing a smaller number of larger loans; however, the fees received by lenders (and the secondary market) are much the same. Indeed, many lenders believe that both Freddie Mac and Fannie Mae have explicit policies against buying mortgages below a certain size (e.g., $25,000 for single-family loans). While such restrictions do not exist, the economic realities are there.

The above factors are more or less inherent in the industry and, to a large degree, reflect the wholesale nature of its operations. There are, however, certain features of the secondary market that are more susceptible to change, most notably its underwriting guidelines and appraisal standards. Both agencies stress that their underwriting criteria should be viewed as guidelines, rather than absolute rules, and that deviations from these basic criteria can occur if "compensating" factors are involved. However, for a variety of reasons, lenders may interpret these guidelines literally and apply a "cookie cutter" approach that requires each individual criterion to be met. Indeed, according to some lenders, Freddle Mac's and Fannie Mae's underwriters frequently err in the same direction, making flexibility more of a goal than a reality at this time.

The remainder of this paper describes particular aspects of the existing guidelines that have proven to be most troublesome for community lending. Both Freddie Mac and Fannie Mae have recently taken steps to address many of the issues noted below - Freddie Mac through formal changes to its Sellers and Servicers Guide, Fannie Mae through a clarifying letter to its existing customers. However, these are relatively recent steps and, as yet, may not be broadly recognized by the lending community. Whether or not these actions will be sufficient to alter existing lending patterns remains to be seen.

Ann B. Schnare, senior vice president and director of ICF Inc. and manager of the firm's Housing and Real Estate Group, discussed the possibility that the underwriting policies and procedures of the Federal Home Loan National Mortgage Association and the Federal Home Loan Mortgage Corporation may inhibit loans to minorities and low-income borrowers. Her remarks were made as comments in a paper delivered at the recent annual housing conference sponsored by Fannie Mae. Following are excerpts from her comments. Additional excerpts appeared in the June 8 issue of The Mortgage Marketplace.

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