The mortgage industry remains deeply uneasy with efforts by Fannie Mae, Freddie Mac and their regulator to experiment with front-end credit risk transfers.
Six trade groups sent a letter recently to the Federal Housing Finance Agency, backing its efforts to test various credit risk transfers, which are designed to attract private capital into the mortgage market and reduce taxpayer’s potential exposure to losses. The groups, including the American Bankers Association, Mortgage Bankers Association and the Financial Services Roundtable, argue that FHFA should continue to experiment with both front-end and back-end deals.
"It is not yet the time and may never be the time to pick a winner," the Oct. 13 letter says.
Yet individual members within that group, like the ABA, expressed reservations about front-end deals, which is made before the loans are originated or securitized. While some see front-end deals as a better way to price the risk of default for loans, community banks and other small lenders fear they will be left behind. They are concerned that large originators will cut sweetheart deals with the government-sponsored enterprises while they do not receive a discount.
ABA is particularly skeptical of front-end risk-transfer deals that are coupled with deeper mortgage insurance. Such transactions can involve reductions in guarantee fees paid by originators or other concessions.
It would "likely create the conditions for large lenders to effectively benefit from volume discounts, which have proven troublesome in the past and which have been remedied through the conservatorship by FHFA," said Joseph Pigg, senior vice president at ABA, in an Oct. 13 comment letter to FHFA.
So far, over 80% of risk-sharing deals involving $693 billion in mortgages have been back-end deals. Such deals, which happen after the loan is closed and sold for securitization, are more widely accepted within the industry. ABA raised fears that with the recent focus on crafting front-end deals, back-end deals may be marginalized.
"Nothing should be done to dissuade or create doubt in the markets about the ongoing commitment of FHFA and the government-sponsored enterprises to 'successful' [back-end] risk transfer mechanisms," the ABA letter said.
ABA also points out that increasing mortgage insurance coverage benefits the two GSEs as opposed to lenders or homebuyers. The "GSEs should be required to pay for deeper MI, not originators or borrowers," ABA said.
In an interview, Pigg said ABA is not opposed to experimenting with front-end deals, but doesn't want to see that become the priority.
"We are not opposed to moving ahead with front-end CRTs," Pigg said.
The FHFA and GSEs are stepping up their experiments with upfront risk-transfer deals that can involve lender recourse, deeper mortgage insurance and other capital market executions that transfer credit risk before Fannie or Freddie acquire the loans.
In the joint letter, ABA and five other trade groups suggest "core principles" FHFA should follow in the development of such transactions.
"Deals should be accessible to participants of all sizes on equivalent terms," according to the joint letter, which was also signed by the Association of Mortgage Investors, Securities Industry and Financial Markets Association and Structured Finance Industry Group.
The six trades also call on FHFA to provide greater transparency regarding the relative costs and benefits of different risk-transfer transactions. "Digging through financial disclosures does not provide needed insight," the joint letter says.
While ABA is wary of front-end deals, the MBA wants to push ahead on front-end deals while increasing the frequency and predictability of back-end transactions.
"Well-conceived upfront risk-sharing pilot programs…can help GSEs better determine which transaction structures are best able to expand the sources of private capital and withstand both the peak and valleys in the credit cycle," wrote David Stevens, MBA president and chief executive, in an Oct. 11 letter.
So far, the GSEs have completed just 12 upfront transactions totaling $12.7 billion and all are "fully collateralized lender recourse transactions," according to the National Association of Home Builders. In these recourse transactions, the lenders agree to reimburse the GSEs for a certain percentage of credit losses on the loans in exchange for a fee or reduction in the guarantee fee.
The Home Builders see a big benefit in front-end deals as a result.
"While both back-end and front-end CRT transactions will benefit the enterprises and reduce risk to taxpayers, if front-end options include a reduction in guarantee fees, consumers and lenders could realize benefits they would not in back-end transactions," according to David Ledford, NAHB executive vice president for housing finance and regulatory affairs.
Ledford also wants the GSEs to test upfront transactions that involve deeper mortgage insurance. Currently, private mortgage insurance covers credit losses up to 25% to 35% of the outstanding loan balance. With deeper mortgage insurance, loss coverage could be increased to 50%.
But deeper mortgage insurance has not been part of the credit risk experiment so far.
"Deeper coverage MI would allow the GSEs to reduce their guarantee fees on mortgage loans commensurate with the cost of the risk they transferred to the mortgage insurers," Ledford says in the comment letter.
The U.S. Mortgage Insurers also argue that deeper MI benefits all lenders, including "small lenders who derive no direct benefits from back-end deals."
Mortgage insurance "works very well for small lenders and deeper-cover MI similarly would work very well for small lenders because it is already part of their current origination process," said Lindsay Johnson, the president of the group, in an Oct. 11 press release.
Mortgage insurance is also available to lenders of all sizes with transparent pricing.
The Urban Institute suggests that the GSEs could develop a market for lender-recourse transactions. "In these transactions, lenders would bid by specifying the reduction in guarantee fees that it requires to absorb the predetermined amount of credit risk on their production," wrote Urban Institute fellows Laurie Goodman, Jim Parrott and Ellen Seidman, along with Moody's Analytics chief economist Mark Zandi in a paper entitled, "How to Improve Fannie and Freddie's Risk Sharing Effort."
Fannie and Freddie could conduct a pilot program, according to the Urban Institute researchers, that would allow small depositories to take on recourse risk for the first 1%, 2% or 3% of credit losses via their regional Federal Home Loan Bank.