In the wake of a tough couple of weeks that have rattled the sub-prime lending industry, Freddie Mac announced on Tuesday that it was cracking down on underwriting standards for those loans it purchases.

The mortgage giant announced that it will cease purchasing subprime mortgages that "have a high likelihood of excessive payment shock and possible foreclosure." Any subprime adjustable rate mortgages (ARMs) or mortgage-related securities backed by subprime loans that Freddie will purchase must have been underwritten to qualify borrowers at the fully-indexed and full amortization rates. The goal, Freddie said, is to protect future borrowers from the payment shock that could occur when their interest rates adjust.



The new rules cover what are commonly referred to as 2/28 and 3/27 hybrid ARMS which currently comprise about 75 percent of the subprime market. These are loans in which rates are fixed for two or three years (sometimes at a "teaser" rate) and then readjust each year for the remainder of the 30 year term.

The company will also limit the use of low-documentation underwriting for those products and strongly urges lenders to set up escrow accounts to collect tax and insurance payments on a monthly basis as is the norm in the non-subprime market. Because of the extensive infrastructure required to collect, service, and disburse escrow funds such accounts are not widely used by subprime lenders and Freddie is merely recommending rather than mandating such accounts. The new requirements will allow the continued use of low documentation underwriting in those cases where borrower income derives from hard-to-verify sources, such as self-employment or those employed in the "cash economy," and will develop a reasonableness standard for stated incomes.

Freddie Mac chairman and CEO Richard F. Syron said in regards to the new standards, "Freddie Mac has long played a leading role in combating predatory lending and putting families into homes they can afford and keep. The steps we are taking today will provide more protection to consumers and enhance the level of underwriting standards in the market."

The corporation's announcement comes on the heels of several other disquieting bits of news about subprime lenders. Earlier this week we reported that British financial giant HSBC announced that it would be writing off 20 percent more bad-debt ($10.56 billion) than it had previously anticipated because of the poor performance of sub-prime loans written by its U.S. subsidiary. Other U.S. lenders such as Washington Mutual have made similar warnings.

Big banks are also getting nervous. They are not, in most cases, subprime lenders themselves, but many provide what are known as "warehouse lines" to mortgage companies which draw money from these revolving lines of credit to temporarily fund new loans until they can sell them on the secondary market. The mortgages themselves are collateral for the lines and, if they should become increasingly hard to sell on the secondary market or fall into default themselves, banks fear they will be stuck with collecting on bad collateral.

According to MarketWatch, many of the big banks like Merrill Lynch and J.P. Morgan are putting the squeeze on mortgage lenders by reducing or totally eliminating warehouse lines and several companies including Ownit Mortgage Solutions, Mortgage Lenders Network, USA, and ResMae Mortgage Corporation have already filed for bankruptcy protection after having their warehouse lines cut.

Another MarketWatch report states that a major index based on subprime mortgage derivatives plunged to 69.39 last Friday, down from 79.04 the previous Monday. This index was over 90 at the beginning of February. At this writing it has not recovered.