Point of View: The Price of Risk Creep: By James Lockhart, Director, Office of Federal Housing Enterprise Oversight.

Excerpts of Mr. Lockhart's remarks about the housing downturn's impact on Fannie Mae and Freddie Mac at the 44th annual conference on bank structure and competition in Chicago are presented as our viewpoint.

As nontraditional lending boomed, the enterprises purchased more alt-A and interest-only mortgages and accepted more loans with higher LTV ratios and lower borrower credit scores, but their pricing of those transactions often did not fully compensate for heightened credit risk. A growing share of borrowers whose first mortgages the enterprises purchased also took out second, "piggyback" loans, yet the enterprises did not have complete information on those seconds and could not fully reflect the actual total LTV ratios in their guaranty fee pricing. Further, despite the growing risk of a house price correction, the pricing models of Fannie Mae and Freddie Mac assumed that house prices would continue to grow at their long-term trend. In sum, market developments and the enterprises' responses increased their mortgage credit risk to a degree that was not fully offset by higher capital or fee income.

Second, subprime, alt-A, and other nontraditional mortgages and the private-label MBS they backed were relatively new and untested financial products whose performance in a period of rising interest rates and low or negative house price appreciation was quite uncertain. Grade inflation in credit ratings of structured securities has been evident for some time, and we have seen numerous previously highly rated private-label MBS downgraded over the past year. Thus, those securities posed credit risk as well as the risk of fair value losses due to falling market prices. Those risks were not fully reflected in the enterprises' initial pricing. At midyear 2007, before the start of the current market turmoil, Fannie Mae and Freddie Mac together held $257 billion in private-label MBS backed by subprime, alt-A and home-equity mortgages. By the end of the first quarter of this year, that total had declined to $206 billion.

Third, the growing risk of a house price correction and the risks posed by subprime and nontraditional mortgages also affected the servicers, mortgage insurers, bond insurers, and even the derivatives providers that are major counterparties of Fannie Mae and Freddie ...