Nearly eight years have passed since the takeover of Fannie Mae and Freddie Mac (collectively the GSEs, or government-sponsored enterprises) by the Federal Housing Finance Agency (FHFA), and there’s no end to the conservatorship in sight. This is despite a consensus among most Republicans and a surprising number of Democrats that the only good GSE is a liquidated GSE.
The problems begin when Republicans and Democrats debate what kind of mortgage finance structure should succeed the GSEs. Beyond principled policy differences, the complexity of the status quo alone confounds reform.
Any overhaul of the GSEs will affect existing mortgage finance programs implemented by several Federal Executive Branch departments: HUD as the umbrella agency for FHA and the Government National Mortgage Association (“Ginnie Mae”), the VA, and the USDA, to name the most obvious ones. In short, tackling the GSEs requires a compelling reform agenda, a capacity to plan change into an already complex structure, and a very big slice of political capital.
To encourage congressional action, five public policy experts (including housing policy experts among them) have recently floated a proposal for a GSE succession: A More Promising Road to GSE Reform, by Jim Parrott, Lew Ranieri, Gene Sperling, Mark Zandi, and Barry Zigas. The proposed National Mortgage Reinsurance Corporation (let’s call it “Norman Mac,” the son of Fannie Mae and Freddie Mac) would create a secondary mortgage market facility that transfers a percentage of mortgage losses through reinsurance.
Most of us, even most homebuyers, would likely be mystified by this new approach, so we need to connect the dots from the way mortgage finance vehicles typically work now to the way they would be under Norman Mac. The common denominator between Norman Mac and mortgage insurers such as the FHA is risk sharing. Most agency mortgage finance initiatives are some form of front-end risk sharing. Reinsurance, in contrast, is back-end risk sharing. A brief excursion through the key front-end risk sharing programs, skipping a ton of GSE history along the way, will help explain how reinsurance is potentially the next step for secondary mortgage markets.
Front-End Risk Sharing
Around the time of the Great Depression, the Federal government began to encourage home ownership through improved mortgage lending practices. A major first step was the insurance or guarantee of a residential mortgage loan at the time of loan origination that would reimburse the lender for losses in the event of a default by the borrower. In exchange for assuming mortgage loan default risk, the Federal government as the insurer or guarantor got to set loan terms, borrower credit standards, and other eligibility standards designed to reduce the risk of default. The basic idea was that a stable, government-regulated market would enable more Americans to own their own homes, a development believed to be good for communities, the economy, and the nation as a whole.
As part of the New Deal, FHA insurance was born in this mold. A few years later, with World War II veterans returning home, the VA offered a guarantee for mortgage loans made to veterans, again using this same basic front-end risk-sharing mold. The growth of FHA and VA, along with the postwar boom in housing, encouraged the growth of private mortgage insurance (PMI) as a specialty product issued by “monoline” insurance companies (that is, an insurance company that sells only one product). For decades, FHA, VA, and PMI served as the most important types of front-end risk sharing for lenders originating mortgage loans for residential housing.
Most insured or guaranteed mortgage loans provide coverage to the lender, with the cost borne by the borrower. FHA mortgage insurance requires the payment of two fees: a one-time mortgage insurance premium charged at closing that can be added to the mortgage amount to be financed, plus an ongoing premium collected by the lender with real estate taxes, insurance, and other escrowed items as part of the monthly mortgage payment. The VA charges an up-front funding fee that, like the FHA, can be financed at closing. PMI policies differ as to payment structures, with options including an up-front fee, a monthly fee, or an increase in the mortgage rate. The one unifying theme about premiums and fees for all three coverages is that, since the financial crisis of 2008, the amount charged borrowers has gone up substantially given the higher rate of mortgage loan defaults and liquidations.
Of the three, only the VA guarantee is, by design, a money-losing program. As an entitlement for veterans regardless of creditworthiness, the VA guarantee program receives congressional appropriations to cover red ink. That said, the VA charges veterans a funding fee to cover program costs not subsidized by Congress.
PMI and most FHA mortgage insurance programs charge premiums that are expected to cover the costs of insurance claims. They usually have, but both insurance types experienced outsized losses as a result of the financial crisis. When the capital reserve of FHA’s largest single-family insurance fund dipped below a 2 percent threshold a few years ago, Congress recapitalized the fund for the first time since its inception.1 A few monoline companies issuing PMI—including certain PMIs issued to the GSEs—were unable to pay claims, accelerating GSE losses. In recent months, hoping to avoid a repeat of this situation, the GSEs have raised eligibility standards for companies issuing PMI coverage.
Lenders traditionally considered the amount of the down payment relative to the value of the residence to be the best indicator of mortgage loan default risk, with 20 percent considered sufficient for a mortgage loan without any insurance or guarantee. For those below the 20 percent minimum, PMI insured mortgage loans with down payments of at least 10 percent while the FHA/VA could provide coverage for even lower down payments. In recent years, with better data available to model the potential for default, borrowers now often have more than one option from a menu of risk-based premiums and fees offered by FHA, VA, and PMI companies.
A concept important for both front-end and back-end risk sharing is the level of insurance or guarantee coverage provided. The FHA typically provides the deepest coverage, with a claim reimbursement formula based upon the full unpaid principal balance of the loan. The VA guarantee legally covers 25 percent of the loan balance, subject to Federal mortgage limits. PMI offers a variety of coverages, with a range of rates depending on loan terms and borrower creditworthiness. A common example for a borrower making a 10 percent down payment on a property bought for $200,000 is PMI coverage for 25 percent of the loan amount ($45,000) with the lender retaining the risk for the remaining loan amount ($135,000).
Enter the Secondary Mortgage Market
Fannie Mae started its life as a Federal agency only a few years after the FHA, in response to the need for a secondary market for FHA-insured mortgage loans. Fannie Mae bought and sold FHA mortgage products during these early years, but the limits of this approach in a growing market for residential mortgage loans soon became apparent. In 1968, Congress changed the status of Fannie Mae to a federally chartered, shareholder-owned corporation. A similar Federal charter for Freddie Mac came a few years later, to make available a secondary mortgage market for the Savings & Loan thrift industry that existed at the time.
As part of the re-organization of Fannie Mae, Congress created a new federally chartered corporation known as Ginnie Mae to assume certain government functions previously performed by Fannie Mae and to develop a mortgage-backed securities program for FHA-insured, VA-guaranteed, and other agency mortgage loans. Consistent with its government charter, Ginnie Mae vastly increased the market for agency mortgage loans by enabling non-lender investors to buy federally guaranteed securities backed by such loans.
While Ginnie Mae guaranteed pools of Federal agency mortgage loans, the GSEs had broader authority for secondary mortgage market transactions. By the 1980s, the GSEs tended to specialize in conventional mortgage loans, including loans with PMI, while Ginnie Mae was the primary funding source for low-down-payment homes for first-time homebuyers originated through FHA or VA.
The mortgage types financed by Ginnie Mae and the GSEs began to change, first starting in 1992, when Congress introduced housing affordability goals for the GSEs under a re-authorized charter. Then, in 2008, the approaching insolvency of the GSEs served as a catalyst for Congress to expand FHA eligibility beyond its traditional but somewhat limited “starter home” role through a change in how the FHA mortgage limits work. By way of background, FHFA computes a conforming loan limit (now $417,000), which determines an FHA limit with a floor of 65 percent of the conforming loan limit (now $271,050). Each respective limit serves as a maximum mortgage amount, except as may be increased to reflect higher-cost areas at a maximum of 150 percent (now $625,500). Congress allowed the higher-cost area maximums to apply equally to FHA and the GSEs, causing overlap in FHA and GSE financing in certain locations for the first time in years.
Big Sister Ginnie Mae
Norman Mac would not operate in a vacuum if it replaced the GSEs. Ginnie Mae will continue to function as a competitor Federal mortgage-backed securities program. We need to take into account a few points about Ginnie Mae before we consider the role Norman Mac might play.2
The key to the success of Ginnie Mae in the secondary mortgage markets is a Federal guarantee that ensures the timely payment of principal and interest to the investor under the mortgage-backed securities. The aggregate of scheduled mortgage payments under the pooled loans, after the deduction of the guarantee fee to Ginnie Mae and the servicing fee to the lender, determines the payment schedule guaranteed by Ginnie Mae. The lender for the pooled mortgage loans typically serves as the Ginnie Mae issuer for such pools and as seller of the newly issued mortgage-backed securities. As guarantor, Ginnie Mae has no role in buying or selling the securities or pooled mortgage loans backing such securities. While Ginnie Mae provides a guarantee of timely payment to investors, the lender has contractually agreed with Ginnie Mae to make all payments under the securities on behalf of Ginnie Mae, advancing funds if necessary to make timely monthly payments, including any mortgage buyouts or payoffs arising from a mortgage loan default. This lender obligation to Ginnie Mae, known as “lender recourse,” is another form of front-end risk sharing. For a lender experienced in FHA/VA lending and Ginnie Mae issuance, the cost of lender recourse can be quantified or approximated so that it becomes a cost of doing business for a Ginnie Mae issuer.
Ginnie Mae’s guarantee of mortgage-backed securities has operated in the black since inception, even during the financial crisis. This successful track record, spanning more than forty years of unprecedented growth, is no accident. Rarely is there a need for Ginnie Mae to make payments to investors under its guarantee. The goal of oversight by Ginnie Mae is to ensure that the lender has adequate capital, credit lines, and sufficient loan insurance or guarantee coverage to make timely payments under the securities.
The most common Ginnie Mae guarantee fee (it can vary among programs) is 0.06 percent, which represents the cost of ensuring timely payment under the securities. This fee has not changed in decades because it covers only the default risk of the lender as issuer under the Ginnie Mae program. The Ginnie Mae guarantee does not cover not the default risk of the borrower under the mortgage loan; that is the responsibility of the FHA, the VA, or other agency providing loan-level coverage.
Back-End Risk Sharing After GSE Conservatorship
Unlike the Ginnie Mae lender recourse model, most GSE secondary mortgage market programs make provisions for the GSE to absorb the risk of loss from mortgage loan default and liquidation (subject to collection under any loan-level coverage such as PMI).3 As might be expected, the GSE guarantee fee has increased substantially to cover mortgage loan default and liquidation losses experienced by the GSEs since the financial crisis, similar to recent premium hikes for PMI and FHA insurance. Following the trend toward risk-based pricing, Fannie Mae has recently added an upfront fee for certain riskier mortgage loans.
Starting in 2013, the FHFA began to consider how the GSEs could structure the sale of some portion of their mortgage loan default risk by entering into sale transactions in the secondary mortgage market. These post-origination, post-acquisition mortgage loan default risk sales are examples of back-end risk sharing. Republicans on Capitol Hill have shown some interest in this approach, suggesting that GSE succession by a reinsurer like Norman Mac could gain bipartisan support.
To date, Freddie Mac has developed three different types of risk-sharing initiatives to appeal to a wide variety of investors. And Fannie Mae reports that, over nine issuances through early 2016, it has sold approximately $66 billion in mortgage securities that included $1.7 billion in derivatives known as “Credit Insurance Risk Transfers.”
A summary of the structure of these initial back-end risk-sharing arrangements is available from various disclosure documents. What isn’t necessarily known are the prices and counter-parties (that is, the entities assuming the risk). And, of course, this initial venture into back-end risk sharing is not sufficiently seasoned to confirm the success of its intended goal of transferring mortgage loan default risk from the GSEs into private hands.
GSE Successor and Ginnie Mae Sibling
As proposed, Norman Mac will start operations with selected employees and assets4 of the GSEs, hopefully inheriting the best they have on offer. The GSEs will wind down operations concurrently with the birth of Norman Mac. What happens to long-suffering GSE shareholders upon the liquidation of the GSE business is uncertain.5
Norman Mac-eligible mortgage loans would look like a plain vanilla, lower-risk version of GSE-eligible loans. Norman Mac will inherit the existing conforming loan limits of the GSEs. At the same time, any mortgage loan financed through Norman Mac must be a “Qualified Mortgage” as defined by the Consumer Financial Protection Bureau. Stepping into the shoes of the GSEs, Norman Mac will be subject to oversight by the FHFA. This differs from Ginnie Mae, whose regulatory home is with the FHA at HUD.
Although Norman Mac is the would-be successor to the GSEs, it will look like a sibling of Ginnie Mae in two important respects. First, Norman Mac will be a government corporation. Second, Norman Mac will issue mortgage-backed securities with a Federal guarantee of timely payment. Because mortgage-backed securities issued by Ginnie Mae and Norman Mac will have the same high Federal credit quality, both will trade in the market based upon agency pricing.
A major operational difference between Norman Mac and Ginnie Mae is the “cash window” inherited by Norman Mac from the GSEs. Unlike the limited guarantee role of Ginnie Mae, Norman Mac will have the ability to buy mortgage loans for cash and issue bonds to finance such loans. With the same authority, the GSEs, publicly owned corporations that borrowed too heavily to buy risky mortgage loans, were close to a debt default in 2008 until the Federal bailout. Norman Mac will not inherit this genetic defect as a government corporation, but the maintenance of a cash window to buy mortgage loans through the issuance of debt will add a layer of complexity to its daily operations.6
A Hybrid Model
In managing mortgage loan default risk, Norman Mac will adopt a hybrid method of both back-end risk sharing through reinsurance and front-end risk sharing through a mortgage insurance fund. Despite the emphasis on reinsurance by its proponents, Norman Mac does not abandon the current model of loan coverage from fees collected at the time of mortgage loan origination.
The primary method of risk sharing through Norman Mac is reinsurance. The risk of loss for the first 3.5 percent of losses for mortgage loans financed through Norman Mac will be transferred to the private market through reinsurance at some point after loan origination. The current back-end risk sharing activities of the GSEs are likely to provide insight into the best way to transfer this credit risk. That being said, difficult market conditions may make regular sales infeasible if pricing levels are unacceptable to Norman Mac. It is also unclear whether transfers will occur through ongoing public auctions or less transparent securities transactions similar to the ones now conducted by the GSEs.
As a second layer of protection—for catastrophic events—Norman Mac will make capital contributions from its guarantee fee to a mortgage insurance fund in the amount of 2.5 percent of the total insurance in force. The FHFA has recently taken the position that a portion of the GSE guarantee fee needs to serve as a capital buffer, so it is not surprising to find a reserve in the current proposal funded from a 0.10 percent fee that is built into the guarantee fee. This second layer of protection, a form of front-end risk sharing, looks like a more robust version of the 2 percent capital reserve for FHA’s biggest single-family mortgage insurance fund.
Proponents find that the two layers of mortgage loan default protection proposed for Norman Mac, aggregating 6 percent, would have been sufficient to prevent the insolvency of the GSEs had they been in place during the 2008 financial crisis.
Like the GSEs, Norman Mac will charge a guarantee fee to cover program operations. In addition to the 0.10 percent fee for the mortgage insurance fund described above, a second 0.10 percent fee built into the guarantee fee will provide contributions to an affordable housing fund. Producing affordable housing from such a fund is certainly a less risky alternative than requiring thinly capitalized GSEs to finance often higher-risk affordable housing.
Norman Mac securities, if structured like Ginnie Mae securities, will trade like Ginnie Mae securities given the equivalent Federal guarantee both would enjoy. Ginnie Mae securities generally trade at a pass-through rate that is about 0.20 percent lower than the pass-through rate for comparable GSE securities. If this 0.20 percent pass-through rate reduction applies, Norman Mac will be able to tack an extra 0.20 percent to the guarantee fee for the mortgage insurance and affordable housing funds described above while offering mortgage loan interest rates consistent with the GSEs. This is because the guarantee fee rate and the servicing fee rate for mortgage securities, when added together, are the combined costs most likely to represent the difference between the interest rate under the mortgage loan paid by the borrower and the pass-through rate of interest paid to the securities investor. This aggregate cost percentage is known in mortgage securities parlance as the spread. Because the proposed guarantee fee rate of Norman Mac is 0.90 percent, and the rate of servicing compensation will follow the 0.50 percent GSE rate, the spread for Norman Mac securities is expected to be 1.40 percent.
Apples, Oranges, and PMI
The spread for the most common Ginnie Mae single-family mortgage-backed securities program is 0.50 percent, in contrast. From this spread, Ginnie Mae receives a guarantee fee of 0.06 percent and the lender receives a servicing fee of 0.44 percent. The Ginnie Mae guarantee fee is low because Ginnie Mae has no obligation for mortgage loan default coverage under its lender recourse model. The lender receives 0.44 percent as compensation given its obligation to pay on amounts due under the securities, regardless of whether a problem arises with the loan-level coverage or for any other reason under its lender recourse obligation to Ginnie Mae.
The spread for Norman Mac securities exceeds the spread for the most common Ginnie Mae single-family securities by 0.90 percent (or 1.40 percent minus 0.50 percent). At first blush, an FHA/VA origination sold into a Ginnie Mae securities pool looks like it has more favorable terms to the borrower because the interest rate of the FHA/VA mortgage loan is 0.90 percent lower than the Norman Mac mortgage loan for securities with the same investor pass-through rate and same pricing as the Ginnie Mae securities. But this is like comparing apples to oranges. The fees charged to the borrower from the applicable front-end risk sharing program need to be considered as part of the financing cost.
The FHA borrower probably left the closing table adding 1.75 percent to mortgage principal to cover the up-front mortgage insurance premium and is now groaning over a monthly mortgage insurance premium escrow that could go beyond 1 percent, depending upon the risk-based mortgage insurance premium set by the FHA. The VA spares its borrowers from an ongoing payment to the VA, but the one-time VA funding fee can range anywhere from 1.25-3.30 percent, depending on down payment, the military status of the borrower, and whether this is the borrower’s first or second use of the program.
Given the substantial cost of FHA/VA coverage after the financial crisis, Norman Mac may prove to be the preferred financing route if the first loss of 3.5 percent can be reliably digested in the private market through reinsurance at expected prices. That’s a big “if” should the market for Norman Mac reinsurance takes years to develop. In a favorable real estate market, higher coupon securities that happen to pass-through liquidation losses may look like a smart purchase; at the bottom of the real estate cycle, the same securities look like mortgage-backed junk bonds.
What is even less certain is the role of PMI coverage for Norman Mac if the first 3.5 percent of mortgage losses can be sold through reinsurance and the next 2.5 percent is covered through a mortgage insurance fund. It appears that Norman Mac could substantially reduce PMI volume.
The Mortgage Bankers Association of America has recently argued against the wholesale abandonment of PMI in favor of back-end risk sharing. Perhaps a few of its experienced Ginnie Mae issuer members might have an interest in a Ginnie Mae lender recourse model using PMI. As previously proposed here, Ginnie Mae could develop a program for the pooling of PMI-insured mortgage loans for lenders and PMI companies with the blessing of Congress.
Norman Mac is worth Congressional consideration as a replacement for the GSEs given its potential to successfully wind down the GSEs. Whether 3.5 percent loss reinsurance can be transferred under acceptable terms under all market conditions has yet to be proven, however. A workable program will likely take years to mature. In the interim, FHA/VA financing through Ginnie Mae will continue to serve as the vital foundation for residential mortgage finance.
1The FHA reverse mortgage for seniors (known as HECM), not the standard FHA mortgage insurance program, was the most important driver of losses for the single-family insurance fund—but that is a subject for another article.
2My TAI essay “This Old Housing Policy” considers in detail the success of Ginnie Mae as a mortgage-backed securities program and its potential role in any GSE resolution.
3While the GSEs have typically not operated under a lender recourse model like Ginnie Mae, they have legal remedies against a mortgage loan seller if such a seller is in breach of its selling agreement—for example, by violating a specific mortgage loan representation or warranty.
4The common securitization platform, an information technology platform that the GSEs have had in development for a few years, is one valuable asset to be included in the proposed transfer to Norman Mac.
5The GSEs have already returned capital to the U.S. Treasury every year since 2012 and will have returned it all by the beginning of 2018.
6In theory, the cash window is for the benefit of the smaller and less capitalized lenders who simply want cash for their mortgage loans. Yet many FHA lenders have suffered from the same size and capital limitations, and have functioned successfully as Ginnie Mae issuers without a cash window, relying upon bank lines to fund a mortgage loan from the date of its closing to the date of the sale of the Ginnie Mae securities; or selling to intermediaries licensed as Ginnie Mae issuers.