Maintaining that the conservatorships of Fannie Mae and Freddie Mac (the GSEs) have caused government involvement in the mortgage market to balloon to unhealthy proportions, the Mortgage Bankers Association (MBA) Monday released the second in a planned series of five concept papers offering its solutions. Today's paper on risk sharing follows Key Steps on the Road to GSE Reform, which suggests that the Federal Housing Finance Agency (FHFA) direct the GSEs to modify the Freddie Mac PC to mirror the exact structure of the Fannie Mae MBS so that these securities would be considered fungible for TBA delivery.
In Up-Front Risk Sharing: Ensuring Private Capital Delivers for Consumers MBA says a situation exists today where the government is crowding out private capital and blocking real competition in the market. MBA's solution to entice private capital back is for FHFA to require the GSEs to offer risk sharing options to lenders at the "point of sale" rather than at the back end by enhancing loans that are already on the GSEs' balance sheets.
The GSEs should be required to accept loans with deeper levels of credit enhancement in return for bona fide reductions in guarantee fees and other loan level charges. MBA says that GSE (g-fees) fees have more than doubledover the last few years even as their acquisition profile shows they are taking on very little credit risk, For example, average credit scores for mortgage purchases prior to the crisis were about 720, today they are 760 and weighted LTV scores outside of HARP originations are several percentage points lower than they were pre-crisis.
With this combination of high fees and ultra conservative underwriting it is not surprising that the GSEs are seeing record profits. "Their revenues are up and their costs are down, not through their execution, but through government fiat and a privileged market position," the paper says.
Providing an option for lenders to secure loan-level private credit enhancement could create effective competition with guarantee fees now averaging 50 basis points. Indications are that FHFA is likely to continue to raise these fees, perhaps to 70 basis points or higher. With an alternative private credit enhancement channel at those higher rates consumers could be saving at least 20 basis points or $400 per year on a $200,000 loan.
Unlike what is envisioned by the current FHFA strategic plan, this risk sharing should occur at the front end of the transaction. FHFA is currently calling for $30 billion in risk sharing by welcoming private capital through additional mortgage insurance after the loans are in their hands. This benefits the GSEs, the taxpayer, and the private insurer but not the borrower. Moreover the GSEs maintain complete control over the transaction.
By moving the insurance transaction to precede the sales lenders would effectively "de-risk" the loans before selling them and the mortgage insurers would be competing for business in the open market across hundreds of lenders rather than through negotiated transactions with the two GSEs.
Where lenders today are responsible for securing credit enhancements - i.e. mortgage insurance or lender recourse - for loans with LTV's above 80 percent, under a front-end risk sharing arrangements the GSEs would provide a reduction in g-fees and LLPA if lenders secured credit enhancement on lower LTV loans or deeper enhancements on higher LTV loans that might lower them effectively to 50 or 60 percent. The result would be a much lower g-fee designed to cover only severe or catastrophic risk.
This pricing tradeoff needs to be transparent and the opportunity to make this tradeoff needs to be open to all approved sellers and to MIs or other credit enhancers that meet rigorous financial safety standards. This risk share structure should be available across the LTV spectrum.
Deep first loss credit enhancements would significantly reduce taxpayer risk in any future distressed economic scenario. Allowing private capital to assume deeper credit risk will result in a reduction of recent guarantee fee increases intended to "crowd-in" private capital, and a net decrease in overall fees and LLPAs. As a result, the benefits of risk sharing gets transferred to consumers.
MBA acknowledges potential concerns about their proposals. First, does it over-rely on private mortgage insurers that are in some cases still recovering from the downturn? MBA says there are risks in any system that relies on private capital. Private mortgage insurers have regulated contingency reserves that largely survived the downturn and in the event of another severe event any form of private capital enhancement that failed would not be bailed out by taxpayers
Importantly, the existing companies have recently been able to raise significant additional equity, and there are new entrants in the market. If this proposal moves forward, many investors, not just traditional mortgage insurers, will likely see opportunity and will bring additional capital into the credit enhancement space where they need to be held to rigorous financial strength standards.
There is also the question of whether the GSEs would be willing participants in this up-front risk sharing. Both are making record profits from guarantee fees and may not be willing to give up the benefits of what MBA calls "crowding out private credit enhancement." MBA says FHFA should require the GSEs to offer a front-end risk sharing program as part of its stated goal of contracting the current footprint of the GSEs in the market while maintaining market liquidity.
MBA's concept paper concludes by saying that the 60 percent of new mortgage originations that are now sold to the GSEs means that the latter's credit pricing has determined and cost of and access to credit for a majority of all new mortgages. By allowing other private credit enhancers to play a meaningful role at the front end of the transaction, competition will be increased and the benefits delivered to both taxpayers and consumers.
