Since the financial crisis, a perennial issue for the mortgage market has been how to increase the share of private capital to support this industry. Thus far, credit risk-sharing programs required by the Federal Housing Finance Agency of Fannie Mae and Freddie Mac have been well-received by private investors and serve as a model for Federal Housing Administration loans.
The FHA finds itself in a delicate position of balancing public policy interests against actuarial soundness of its $1 trillion plus Mutual Mortgage Insurance Fund. These twin policy goals at times run counter to each other, occasionally spilling over into the conventional-conforming market via FHA premium changes that create market distortions and adverse selection problems for the FHA.
Introducing credit risk-sharing to FHA loans would allow the agency to further its mission while enhancing the MMIF’s long-term viability and increasing stability of the overall mortgage market.
The latest FHA actuarial report shows that the largest segment of the MMIF represented by single-family mortgages (referred to as the Forward Portfolio) remains below the congressionally mandated 2% threshold, although the economic value of the portfolio improved to $17 billion in 2015.
By contrast, in 2012 and 2013, the Forward Portfolio reported economic losses of $13.5 billion and $7.9 billion, respectively. Improvement in the Forward Portfolio has sparked some questions as to whether FHA insurance premiums should be lowered given the recovery of the MMIF. Therein lies the crux of FHA’s conflicted mission.
There is no mechanism to prevent changes in FHA insurance premiums that run counter to securing the MMIF’s minimum capital ratio. And that ratio is itself well below what would be considered to be at a prudent level.
The MMIF’s statutory capital ratio is based on a view of how the portfolio over time will perform across an average of various economic scenarios. However, this is far less than what a bank or insurance company would be required to hold.
Such firms, in addition to holding reserves for expected credit losses, must add an amount to cover unexpected losses. The FHA Actuarial Report estimates what would happen to the fund should such an unexpected outcome arise. Running the Forward Portfolio through an economic scenario that results in a protracted economic slump (not a remote event given today’s global volatility), the economic value of the fund would be loss of $57.3 billion.
Lowering premiums at a time when the fund remains below the statutory threshold and under a framework that has it holding nothing for unexpected losses places the fund at-risk in the future.
This is further exacerbated by FHA’s lack of resources and expertise to accurately price its premiums.
FHA could reduce its potential exposure in its MMIF by engaging in programs similar in concept to those being used by the GSEs today. According to the FHFA, nearly 50% of GSE acquisitions are covered by some form of credit risk transfer.
A similar process could be implemented for FHA. FHA loans could, for example, be aggregated into a reference pool against which credit losses are allocated to one of several tranches for sale to the private market. Investors would most likely gravitate to a first loss (junior) or mezzanine tranche, leaving the senior (or catastrophic) losses to the FHA, a natural holder of this risk by virtue of its federal guarantee.
This type of structure would not adversely affect the existing Ginnie Mae TBA MBS market since the loans would already be placed into an MBS.
In theory there is nothing preventing such programs from taking place. But there are important issues that would need to be addressed.
First, the FHA, unlike the GSEs, does not possess the expertise to execute credit risk transfer on any scale, so an infrastructure would need to be put in place to do this.
Second, there currently is no policy allowing credit risk to be transferred by the FHA on its single-family loans. However, there is some precedent for their multifamily programs. Section 542(b) of the Housing and Community Development Act of 1992 allowed FHA to engage in reinsurance programs on a 50-50 basis with the GSEs and qualified financial institutions.
Third, experience with the private label markets showed that private investors can be fickle when markets deteriorate.
Today, about 84% of all GSE credit risk-sharing transactions have been with asset managers and hedge funds.
While the verdict is out on the stability of those investor types over time, private mortgage insurance companies have the capital strength, expertise and demonstrated ability to play a prominent role in risk-sharing in all market environments.
Recent private mortgage insurance eligibility requirements imposed on mortgage insurance companies by the GSEs further bolstered the strong capital base of these firms. And their expertise in insuring high LTV loans makes them a natural risk-sharing partner with FHA.
While obstacles exist to implementing a viable risk transfer program, the benefits would be significant.Distributing a portion of credit risk from FHA loans to private investors reduces the risk to the MMIF over the long-run and to taxpayers. The bidding process among private investors for FHA risk-sharing transactions will ensure an efficient transfer of risk from FHA to other market participants. Such a process will also provide more realistic pricing of FHA credit from risk-sharing participants, help stabilize pricing distortions across GSE and FHA mortgages and reduce potential adverse selection of FHA while supporting the agency’s mission to promote affordable housing.
