Senate Draft's Cross Subsidy Approach Misses the Mark
March 01, 2018
A wholesale reconstruction of the country’s mortgage finance system is a rare opportunity to take all of the federal government’s direct and indirect supports for home finance and use them to create a sensible system that protects taxpayers, assures full access to credit, and supports liquidity for the long term, fixed rate mortgages that consumers prefer. But the draft GSE reform bill that was widely circulated in late January instead perpetuates the current separation of the so-called “conventional” market from the government market supported by FHA, VA and RHS. The draft could use the government’s various existing forms of mortgage credit insurance as a conscious part of a new secondary market model in order to assure a broad and responsible spectrum of credit risk at the most affordable cost to consumers. Instead, the system would divert the proceeds of a 10 basis point fee on guaranteed securities from supporting rental housing and community development efforts for very low income households to a new form of cross subsidy that effectively will subsidize private Mis and the new guarantors.
Even with the draft’s proposed subsidy, the draft will leave a significant portion of the market to FHA. Borrowers with very little cash to put down and moderate credit scores will still find FHA their most economical choice. The subsidy will pull some share of borrowers into the private system, but it will not do so for them all. Even with its problems, FHA will remain a major part of the federal system of support for home ownership finance. The draft’s failure to incorporate it more intentionally into its proposed new structure is a missed opportunity.
There are other concerns with the draft, including the lack of enforceable standards of service to under served communities and borrowers for the new guarantors. Subsequent versions may change its outlines significantly. But Congress faces what will hopefully be a once in a generation opportunity to redefine federal support for mortgage finance. Its goal should be a durable, comprehensive system. Trying to solve broad challenges of access in the market by isolating a new privately funded system from the government’s other supports will only perpetuate the uncoordinated and unsatisfactory system we have today. We can and should do better than that.
Private Guarantors and Risk Based Pricing
The draft would rely on newly chartered private guarantors operating with market-priced capital. It also would require these guarantors to off load much of the credit risk to others, like MIs. In turn, this would drive risk-based fees for their credit insurance and that of their risk sharing partners. Borrowers with higher risk profiles – typically those with lower down payments and lower credit scores – would be charged progressively higher fees. The bill would use the 10-basis point fee to offset these risk-based costs for certain borrowers. The draft defines these as borrowers with incomes below 80 percent AMI (or first-time homebuyers below 100 percent AMI). A recent Urban Institute analysis suggests that this could range from between $929 and $236 in yearly mortgage cost savings, depending on a family’s income. This effectively would shift the fee’s proceeds from supporting affordable rental housing for families at or below 30 percent of AMI, and community development efforts that support LMI communities, to helping some unknown number of aspiring homebuyers with a modest subsidy.
Such a subsidy might be justified if many consumers would be denied mortgage credit without it, or a ready means to provide lower cost insurance to the same borrowers was not readily available. But, in reality, FHA is and will remain consumers’ alternative when it can offer a better “sticker price” than privately capitalized credit insurance. (The same is true of insurance programs offered by the VA and USDA’s Rural Housing Services, but FHA will be the likely alternative for most consumers.)
An expansive and inclusive approach that consciously incorporates existing mission driven government supported mortgage credit insurance alongside that offered by the privately capitalized guarantors and their risk sharing partners like MIs would assure a broad range of credit pricing and availability through the proposed new securitization platform without needing to use the proposed new fee to subsidize market-priced risk. This might even spur competition from these private insurers, which could expand private capital’s role in serving more borrowers without requiring the proposed subsidy. It also could help strengthen FHA's book by adding borrowers with relatively stronger credit and countering some of the adverse selection it otherwise will suffer.
Instead, the draft would use most of the 10-bps fee to reduce the impact of market driven pricing for some borrowers, and enable Mis and the guarantors to employ full risk based pricing without losing some borrowers to a cheaper FHA execution. Relying on FHA to provide this cross subsidy in the overall system also would reduce the impact of market pricing without needing to divert the fee.
The 10-basis point fee’s original purpose was to generate a dependable source of funding for desperately needed affordable rental housing production and preservation, and support for community development investments, along with a modest set aside for supporting market expanding activities through a newly structured mortgage finance system. It was meant to replace a far more modest annual assessment under the 2008 HERA legislation governing Fannie Mae and Freddie Mac, which has generated several hundred million dollars in support for the Housing Trust Fund and Capital Magnet Fund in each of the last few years. This would still be the highest and best use of the fee. Diverting it might move the proposed system’s reach a little further in FHA’s direction. But it would not actually add any new mortgage borrowers to the federal government’s overall coverage. Drafters could restore some of this funding by increasing the fee. But this would only add more cost for all consumers in the system while bypassing FHA’s ability to support a cross subsidy for higher risk borrowers.
Alternative Approaches
There are multiple ways the bill’s higher market-driven costs to consumers could be mitigated. The Mortgage Bankers Association 2017 proposal for multiple private guarantors, which is a partial blueprint for the draft, included utility-like regulation of new guarantors’ returns, controlling their costs and potentially enabling lower overall charges to consumers. Private mortgage insurers and guarantors could be regulated to use less loan level risk-based pricing and more broad pool pricing of risk. The new guarantors could be required to accept lower returns for loans serving a defined group of borrowers, as Fannie and Freddie are required today, forcing the cross subsidy to be borne by the guarantors benefitting from the securities guarantee. The drafters could reduce the amount of insurance in front of the government and use the government securities guarantee, which would not rely on loan level risk-based pricing, to cover more of the risk. They could encourage the development of risk sharing pilots combining FHA and private mortgage insurance as has been suggested by others for years. It also could include participation by other mission-driven market participants such as state housing finance agencies, Federal Home Loan Banks, and CDFIs like Self Help Venture Fund, which already operates a competitive and successful credit enhancement program with Freddie Mac, to diversify credit insurance offerings and deliver more value to consumers.
Even if the entire 10 bps in the Senate draft, estimated to be an annual flow of about $5 billion once the new system is up and running, is diverted to cross-subsidizing the private credit insurers, there will still be borrowers for whom the price of a loan under the new system is higher than the price of a loan with FHA insurance. Indeed, a recent Urban Institute analysis concludes that the draft’s proposed use of the fee is unlikely to reduce FHA’s market share from what it has today. But it will cost billions in explicit subsidies to produce this result. Relying more on FHA would expand its market share. But it would help create a broader range of credit pricing across the system, and probably strengthen rather than weaken FHA's own insurance book.
Government programs like FHA and VA offer alternate, less costly mortgage insurance featuring broad risk pooling and attendant average risk pricing. They charge lower rates for weaker credit borrowers than privately capitalized insurers will offer because of their explicit government sponsorship and support, and their mission-based approach. They have a track record over more than 80 years. The sensible course would be to exploit this valuable resource and rely upon it as an affordable alternative form of primary credit insurance alongside the draft’s totally free market pricing model. Integrating these approaches would produce a broad policy approach to mortgage credit access that would mix public and private support to reach the best solution for taxpayers and borrowers. In contrast, the net effect of the proposed cross subsidy in the Senate draft really will be to use the 10-basis point fee to shift market share from affordable government-supported insurance that is already available at a competitive price to private insurance.
The draft also would give FHFA or its successor new responsibilities to design, execute and monitor other more direct forms of subsidy contemplated in the draft, such as down payment assistance, or consumer counseling support. But HUD, the VA and the Department of Agriculture’s Rural Development Administration, and state and local governments, already have the capacity and expertise to do this. If this is such an important outcome, the Housing Trust Fund’s purposes could be enlarged to include specific attention it. Why add these tasks to yet another federal department that should be laser-focused on the government’s total exposure to mortgage credit risk and the larger mortgage finance system’s stability and liquidity?
FHA Also Has Issues
New legislation need not tackle the myriad administrative problems plaguing FHA for the FHA (as well as VA and RHS) to continue to play a principal role in making mortgage credit affordable. But there is no doubt that much should be done to tackle FHA’s outdated technology, inadequate quality control and counterparty risk management. Lenders remain wary of FHA’s reliability. The loan level certifications lenders must sign, and the risk of False Claim Act prosecutions for errors in loan manufacturing are handicapping FHA’s market role. HUD’s leadership, lenders, consumer advocates and congressional leaders are pushing for sensible reforms to FHA and they need to continue to do so.
But FHA in the meantime will continue to play a major role in the mortgage finance system. Not including its ability to offer lower cost mortgage insurance that is average priced and provides access to lower wealth borrowers and those with weaker credit wastes a valuable resource and perpetuates a separation among the government's various direct and indirect supports for mortgage credit.
The leaked draft's design may not move forward. I joined with other co-authors to recommend a different approach that did incorporate FHA more fully. But any system that relies on private capital to absorb losses ahead of a government securities guarantee will have to confront the challenge of how to insure broad access for responsible borrowers in the face of private sector return expectations. Failing to take advantage of FHA in a comprehensive system would miss an important chance to use an existing tool and to more closely integrate the government's approaches to supporting mortgage finance.