OFHEO has identified as a benchmark the 30- year, fixed-rate mortgages originated in Arkansas, Louisiana, Mississippi and Oklahoma in 1983 and 1984, just before oil prices collapsed. During the first five to six years into the lives of these loans, house prices in the region fell about 16 percent. As a result, the 1983 and 1984 vintage mortgages purchased from that region by the two companies experienced high levels of failure. OFHEO's research shows that these mortgages defaulted at an average 14.9 percent in their first 10 years, leading to dollar losses equaling 63.3 percent of the original principal balance of the loans
Note the phrase 1983 and 1984 vintage mortgages. Today, those would be the equivalent of mortgages originated in 2006 and 2007. Older mortgages would tend to default at a much lower rate, because the underlying houses experienced appreciation before prices began falling.
2. David Min's chart shows the rate of serious delinquency for mortgages as of Q2 2010. For "prime" mortgages, this is 7 percent.
3. As far as I can tell, Min's data includes all vintages of mortgages, not just the 2006 and 2007 vintages that should have been most vulnerable to house price declines. For example, a 2001 mortgage should have experienced significant underlying appreciation on the home, so that the borrower's equity would still be positive today.
4. As far as I can tell, Min's data is a snapshot of mortgages that were delinquent as of Q2 2010. So that if a loan went into foreclosure in 2008 or 2009, it would not count in his data. What we really want is the cumulative default rate on mortgage loans that were made in the boom years. If I am right that the 7 percent delinquency rate is only a snapshot, and not a cumulative number, then Brad DeLong's arithmetic is beside the point, or to use his word, silly.
5. The answer to the question I posed to Brad is that the guarantee fee is about 20 basis points. The agencies need to keep losses below 20 basis points in order to break even.
6. The present value of 20 basis points of guarantee fee is obtained by multiplying 20 by the DV01, which means dollar value of one basis point. Twenty years ago, the DV01 for a 30-year mortgage was between 4 and 5. Assuming it has not changed since the days when I was doing default cost analysis, the present value of the guarantee fee is about 100 basis points, or one percent.
7. If you lose 50 percent of the loan amount in a default (note the OFHEO estimate of 63 percent), that means that you cannot afford more than a 2 percent default rate. Otherwise, you lose more than 1 percent in present value, which exceeds the DV01 of the guarantee fee.
8. Even with a default rate higher than 2 percent, Freddie and Fannie could have survived. They were making profits on their portfolio holdings (the difference between the interest rates on mortgages and the rates on agency debt), and they held capital, which by itself was supposed to enable them to survive a severe downturn in house prices. But Freddie and Fannie blew through their profits on their portfolios as well as their capital.
9. It would be interesting to try to simulate Freddie and Fannie's performance assuming the same path of house prices but a mix of loans purchased in 2004-2007 that looks more like the loans purchased in 1994-1997 in terms of loan-to-value ratio, loan purpose, and credit score. I bet that Freddie and Fannie would have come through the housing crash just fine under such a simulation.
10. It would be interesting to try to simulate what the housing market as a whole would have done without Freddie and Fannie's support for high-risk lending. My bet is that the boom and the bust would have been a good deal milder.