Not Perfect? Freddie Mac Wants You

Thousands of home mortgage applicants with less-than-perfect credit files could qualify for lower interest rates on their loans, thanks to the entry of a huge new lender into the so-called “sub-prime” market.

Freddie Mac, a federally chartered, privately run financial institution, surprised the mortgage industry recently by revealing that it plans to purchase up to $2.5 billion worth of sub-prime home mortgages during the coming year. The money could fund as many as 40,000 home refinances or purchases nationwide, according to a company spokesman.

The sub-prime market--often called B and C lending in the mortgage trade--serves applicants who have been late in paying their monthly credit card or other debts, including their home loans.

The more serious the credit problems borrowers have in their credit histories, the lower they rank on the alphabetical scale of credit risk and the higher the interest rates and fees they’re charged.

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For example, some lenders define B applicants as those who have been late as much as 60 days in the last 12 months on a charge account debt, 30 days late on their mortgage once in the last 12 months and who have an overall debt-to-household income ratio above 40%. Applicants with B ratings often are charged at least a full percentage point higher rate than prime or A borrowers, and they will probably pay higher loan fees at settlement.

Borrowers in the C category, by comparison, may have been 30 days late in payments two or three times on their home loans, 60 days late on credit card payments several times and have even higher debt-to-income ratios. They may be charged 2 to 2 1/2 percentage points higher than A borrowers.

Applicants with even deeper dents in their credit files, such as a long-term delinquency, a mortgage foreclosure or a bankruptcy, tend to fall into the D category. They pay top dollar for any mortgage credit they get: Rates of 14% or higher are commonplace, and they tend to face severe restrictions on the amount of mortgage money they can borrow relative to the value of their home.

Freddie Mac and its rival mortgage powerhouse, Fannie Mae, traditionally have financed only borrowers in the A credit category. But in a dramatic policy switch, Freddie Mac has concluded that it’s prepared to handle the extra risks presented by the B and C levels of the home mortgage market.

In a recent interview Freddie Mac Vice President James Cotton said his company wants to “bring down costs and bring new efficiencies” to the entire B and C marketplace by expanding the capital base available to fund such loans and to bring its sophisticated risk-scoring technologies to a segment of the market that could benefit from them dramatically.

Cotton said Freddie Mac initially will purchase loans from well-known sub-prime mortgage providers like the Money Store and Advanta Mortgage Corp. As time goes on, however, Freddie Mac is expected to purchase loans from a wide variety of local and national lenders.

Asked to estimate the effect on consumers, Cotton said that cost savings “eventually” could be one-half to three-quarters of a percentage point off prevailing rates.

A B borrower who would normally pay, say, 11% with two points for a loan might pay 10 1/4% with two points, thanks to Freddie Mac’s presence in the market, he said. (A point equals 1% of the loan amount and typically is paid at close.) Cotton cautioned against consumer expectations of even greater cost reductions.

“You’re not going to see an 11 1/2% rate go to 8 1/2%,” he said. “That just won’t happen.”

A key factor in Freddie Mac’s decision to enter the sub-prime market is its growing confidence in the accuracy of the electronic risk-evaluation tools the company has developed in the last several years.

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It uses behavioral risk scores to identify borrowers who present the greatest likelihood of default, foreclosure and bankruptcy. Borrowers whose loans are funded by Freddie Mac are analyzed at application for credit risk.

Once funded, they are also monitored for early signs of credit problems requiring intervention to help prevent extended defaults or foreclosure.

Because the company knows how to spot B and C credit risks upfront and has developed techniques to work with borrowers heading for financial hot water, its executives believe that it’s appropriate--and potentially profitable--to invest in higher-rate mortgages.

Will Fannie Mae follow suit and help bring down rates even more? Fannie Mae spokesman Gene Eisman said, “We have no plans” to do so. “Our goal is to expand the overall number of people who get a loan in the A market,” he said, by cutting application costs and improving underwriting with credit scoring.

But industry observers predict that if Freddie Mac begins to succeed in the sub-prime market, Fannie Mae will jump in as well. The bottom line will be lower costs and better terms for anyone who needs a mortgage but doesn’t quite make the grade.

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Distributed by the Washington Post Writers Group