In their search for ways to shift the credit risk of mortgages from taxpayers to capital markets, Fannie Mae and Freddie Mac may be overlooking important players: the lenders that make these loans in the first place.
The government-sponsored enterprises now share risk on about 90% of the balance of newly acquired 30-year fixed-rate mortgages, their core business. But so far, they are relying primarily on transactions that offload risk after they have acquired these loans, leaving taxpayers on the hook for a time. And the two biggest programs, Structured Agency Credit Risk (Freddie) and Connecticut Avenue Securities (Fannie), have a limited investor base.
Mortgage bankers would like a shot at shifting some of this risk before they sell loans to Fannie or Freddie, either via private mortgage insurance or by retaining it themselves. In exchange, they would negotiate a reduction in the fees the government-sponsored enterprises charge for their guarantees.
Earlier this month, David Stevens, chief executive of the Mortgage Bankers Association, penned a letter to Mel Watt, director of the Federal Housing Finance Agency, asking the regulator to incorporate explicit targets for this kind of "front end" risk sharing in the GSEs' 2016 scorecard.
Stevens' letter focuses on mortgage insurance, which he says would be "operationally easiest" for the vast majority of lenders.
Leveling the Playing Field
"The MBA believes that up-front risk sharing should be approached in a manner that maximizes the opportunity for the market broadly, and should not advantage certain lenders relative to others," the letter states.
Private mortgage insurance has traditionally been used to reduce the potential losses on low-down-payment mortgages, those with down payments of less than 20%. The idea is to have private mortgage insurance absorb even more of the losses, making the risk to Fannie and Freddie equivalent to that on a mortgage with a 50% down payment.
In exchange for taking on this risk, mortgage lenders would negotiate a lower "G-fee." This discount would be passed on to borrowers in the form of a lower interest rate, offsetting the cost of the additional mortgage insurance premium. "So the all-in payment for a borrower has got to be at least the same, and potentially less," Michael Fratantoni, the MBA's chief economist, said in an interview.
"Ideally, borrowers are no worse off, or even better off," he said.
This kind of tradeoff could also make some lenders willing to lend to more borrowers, increasing access to credit. Currently many lenders don’t make loans with LTVs above 80%.
The MBA sees a lot of fat in G-fees.
Fannie and Freddie are now charging more than twice as much as they did a few years ago, even though they are taking on less credit risk than they were before the financial crisis. For example, average credit scores for GSE mortgage purchases prior to the crisis were about 720; today they are 760. Similarly, the weighted average LTV of loans outside of the Home Affordable Refinance Program are in the high 60 range, several percentage points lower than in the early 2000s.
By lowering effective LTVs to 50 or 60, lenders expect to be able to negotiate G-fees that are substantially lower, perhaps in the single digits. The rationale? Only in a catastrophic situation are homes likely to lose more than half of their value, resulting in losses that Fannie or Freddie must make good.
Increased Counterparty Risk
While deeper mortgage insurance would bring more private capital into the mortgage market, it would also require the GSEs to take on more exposure to private mortgage insurers, which took a beating of their own during the financial crisis. Some were unable to pay all of their claims, resulting in losses to Fannie and Freddie, and, ultimately, to taxpayers.
U.S. Mortgage Insurers, a trade group, has proposed doing a pilot program of $50 billion in deep cover with private mortgage insurance in 2016. A study the trade group commissioned from consultancy Milliman posits that a program taking insurance coverage to 50% LTV on this amount of GSE loans would require private mortgage insurers to hold $720 million of additional capital for the 2016 book year.
USMI President and Executive Director Lindsey Johnson said the industry has ample capital to do this today. "The MI industry definitely has capacity to go down to 50% LTV for loans in the above 80 LTV space," she said in an interview.
Johnson noted that the industry has attracted over $9 billion in new capital since the crisis.
She also pointed out that insurers have new higher capital standards and are subject to rigorous operational oversight under the Private Mortgage Insurer Eligibility Requirements issued by the GSEs. They also implemented new master policies that provide greater clarity and assurances about the consistent handling and payment of MI claims, bringing greater transparency to contractual protections for lenders and investorWhy stop at an effective LTV of 50, aside from the fact that it's a nice round number?
Under current mortgage-insurance requirements, depending on size of the down payments, for some mortgages, mortgage insurance covers down into the mid-60s already. "While it may not sound like that big of a difference, by covering the additional amount down to 50% LTV, you can nearly double the amount of loss protection afforded to the GSEs and thus the taxpayer," Johnson said.
Lack of Disclosure on Lender Recourse
There's another way for lenders to "derisk" loans before selling them to Fannie and Freddie: by keeping this risk on their own books, at least initially. To date, only a handful of mortgage lenders have engaged in such transactions. Two real estate investment trusts, Redwood and Penny Mac, have sold loans to Fannie in which they retained the first-loss position. Redwood absorbed the first 1% of losses in one such deal and Penny Mac the first 3% or so in another, both in 2014. Two other lenders have sold loans to Fannie via transactions in which they absorbed the first 4% to 5% of the risk, but later sold this exposure to a third party. JPMorgan was the first to do so, in 2014; both Wells Fargo and JPMorgan did deals this year.
Stanford Kurland, founder, chairman and chief executive of Penny Mac, made a case for lender recourse transactions in an op-ed published in September. Kurland said these deals align market incentives. "Investors in private securities and loan servicers have every stake in the success of the loan and the homeowner because they know they will bear the bulk of the losses," he wrote.
But Fannie and Freddie don't disclose the level of G-fee discounts that these lenders negotiated, which might entice more lenders to participate. That is a major weakness, according to the Urban Institute paper, which was co-authored by Laurie Goodman, Jim Parrott and Mark Zandi.
The paper notes that lender recourse transactions are only practically available to larger lenders, which may use them to gain an advantage over other originators. "To mitigate this risk, the GSEs must take care not to underprice the guarantee fee charged in these transactions and keep the cash window to the GSEs open for lenders of all sizes."