Fannie, Freddie and Climate Change

NOAA / National Climatic Data Center

The Housing Finance Policy Center at the Urban Institute issued its September 2017 Housing Finance At A Glance Chartbook. The introduction asks what the recent hurricanes tell us about GSE credit risk transfer. But it also has broader implications regarding the impact of climate-change related natural disasters on the mortgage market:

The GSEs’ capital markets risk transfer programs that began in 2013 have proven to be very successful in bringing in private capital, reducing the government’s role in the mortgage market and reducing taxpayer risk. Investor demand for Fannie Mae’s CAS and Freddie Mac’s STACR securities overall has been robust, in large part because of an improving economy and extremely low delinquency rates for loans underlying these securities.

Enter hurricanes Harvey, Irma and Maria. These three storms have inflicted substantial damage to homes in the affected areas. Many of these homes have mortgages backed by Fannie Mae and Freddie Mac, and many of these mortgages in turn are in the reference pools of mortgages underlying CAS and STACR securities. It is too early to know what the eventual losses might look like – that will depend on the extent of the damage, insurance coverage (including flood insurance), and the degree to which loss mitigation will succeed in minimizing borrower defaults and foreclosures.

Depending on how all of these factors eventually play out, investors in the riskiest tranches of CAS and STACR securities could witness marginally higher than expected losses. Up until Harvey, CRT markets had not experienced a real shock that threatened to affect the credit performance of underlying mortgages (except after Brexit, whose impact on the US mortgage market proved to be minimal). The arrival of these storms therefore in some ways is the first real test of the resiliency of credit risk transfer market.

It is also the first test for the GSEs in balancing the needs of borrowers with those of CRT investors. In some of the earlier fixed severity deals, investor losses were triggered when a loan went 180 days delinquent (i.e. experienced a credit event). Hence, forbearance of more than six months could trigger a credit event. Fannie Mae put out a press release that it would wait 20 months from the point at which disaster relief was granted before evaluating whether a loan in a CAS deal experienced a credit event. While most of Freddie’s STACR deals had language that dealt with this issue, a few of the very early deals did not; no changes were made to these deals. Both Freddie Mac and Fannie Mae have provided investors with an exposure assessment of the volume of affected loans in order to allow them to better estimate their risk exposure.

So how has the market responded so far? In the immediate aftermath of the first storm, spreads on CRT bonds generally widened by about 40 basis points, meaning investors demanded a higher rate of return. But thereafter, spreads have tightened by about 20 basis points, suggesting that many investors saw this as a good buying opportunity. This is precisely how capital markets are intended to work. If spreads had continued to widen substantially, that would have signaled a breakdown in investor confidence in future performance of these securities. The fact that that did not happen is an encouraging sign for the continued evolution of the credit risk transfer market.

To be clear, it is still very early to reasonably estimate what eventual investor losses will look like. As the process of damage assessment continues and more robust loss estimates come in, one can expect CAS/STACR pricing to fluctuate. But early pricing strongly indicates that investors’ underlying belief in these securities is largely intact. This matters because it tells the GSEs that the CRT market is resilient enough to withstand shocks and gives them confidence to further expand these offerings.

G-Fee Entreaty

The FHFA has issued a Request for Input about Fannie Mae and Freddie Mac Guarantee Fees. The Request both provides a good explanation of g-fees and poses important questions about their appropriate role in the functioning of the housing finance system. The Request opens,

On December 9, 2013, the Federal Housing Finance Agency (FHFA) announced proposed increases to guarantee fees (g-fees) that Fannie Mae and Freddie Mac (the Enterprises) charge lenders. The Enterprises receive these fees in return for providing a credit guarantee to ensure the timely payment of principal and interest to investors in Mortgage Backed Securities (MBS) if the borrower fails to pay. The MBS, in turn, are backed by mortgages that lenders sell to the Enterprises.

 The proposed changes included an across-the-board 10 basis point increase, an adjustment of up-front fees charged to borrowers in different risk categories and elimination of the 25 basis point Adverse Market Charge for all but four states. On January 8, 2014, Director Melvin L. Watt suspended implementation of these changes pending further review. (1)

The Request asks for responses to 12 questions. The most important, as far as I am concerned, is the first: “Are there factors other than those described in section III – expected losses, unexpected losses, and general and administrative expenses that FHFA and the Enterprises should consider in setting g-fees? What goals should FHFA further in setting g-fees?” (7)

Setting the g-fee has far-reaching consequences not just for the financial health of the two companies, but also for the health of the overall housing market and the mortgage industry. It will also have predictable effects on the litigation over the conservatorships of the two companies. For instance, a high g-fee will make the two companies appear to be more valuable than a low one. The size of the g-fee may also impact the scope of federal affordable housing initiatives.

While this Request for Input is pretty technical (particularly the parts of it that I didn’t blog about), it touches on some of the most fundamental aspects of our system of housing finance. As such, it invites responses from more than just industry insiders. Input is due by August 4th.