De Facto Housing Finance Reform

photo by The Tire Zoo

David Finkelstein, Andreas Strzodka and James Vickery of the NY Fed have posted Credit Risk Transfer and De Facto GSE Reform. It opens,

Nearly a decade into the conservatorships of Fannie Mae and Freddie Mac, no legislation has yet been passed to reform the housing finance system and resolve the long-term future of these two government-sponsored enterprises (GSEs). The GSEs have, however, implemented significant changes to their operations and practices over this period, even in the absence of legislation. The goal of this paper is to summarize and evaluate one of the most important of these initiatives – the use of credit risk transfer (CRT) instruments to shift mortgage credit risk from the GSEs to the private sector.

Fannie Mae and Freddie Mac have significant mortgage credit risk exposure, largely because they provide a credit guarantee to investors on the agency mortgage-backed securities (MBS) they issue. Since the CRT programs began in 2013, Fannie Mae and Freddie Mac have transferred to the private sector a portion of the credit risk on approximately $1.8 trillion in single-family mortgages (as of December 2017; source: Fannie Mae, 2017, Freddie Mac, 2017). The GSEs have experimented with a range of different risk transfer instruments, including reinsurance, senior-subordinate securitizations, and transactions involving explicit lender risk sharing. The bulk of CRT, however, has occurred via the issuance of structured debt securities whose principal payments are tied to the credit performance of a reference pool of securitized mortgages. A period of elevated mortgage defaults and losses will  trigger automatic principal write-downs on these CRT bonds, partially offsetting credit losses experienced by the GSEs.

Our thesis is that the CRT initiative has improved the stability of the  housing finance system and advanced a number of important objectives of GSE reform. In particular the CRT programs have meaningfully reduced the exposure of the Federal government to mortgage credit risk without disrupting the liquidity or stability of secondary mortgage markets. In the process, the CRT programs have created a new financial market for pricing and trading mortgage credit risk, which has grown in size and liquidity over time. Given diminished private-label securitization activity in recent years, these CRT securities are one of the primary ways for private-sector capital market investors to gain exposure to residential mortgage credit risk.

An important reason for this success is that the credit risk transfer programs do not disrupt the operation of the agency MBS market or affect the risks facing agency MBS investors. Because agency MBS carry a GSE credit guarantee, agency MBS investors assume that they are exposed to interest rate risk and prepayment risk, but not credit risk. This reduces the set of parameters on which pass-through MBS pools differ from one another, improving the standardization of the securities underlying the liquid to-be-announced (TBA) market where agency MBS mainly trade. Even though the GSEs now use CRT structures to transfer credit risk to a variety of private sector investors, these arrangements do not affect agency MBS investors, since the agency MBS credit guarantee is still being provided only by the GSE. In other words, the GSE stands in between the agency MBS investors and private-sector CRT investors, acting in a role akin to a central counterparty.

Ensuring that Fannie Mae and Freddie Mac’s credit risk sharing efforts occur independently of the agency MBS market is important for both market functioning and financial stability. The agency MBS market, which remains one of the most liquid fixed income markets in the world, proved to be quite resilient during the 2007-2009 financial crisis, helping to support the supply of mortgage credit during that period. The agency market financed $2.89 trillion of mortgage originations during 2008 and 2009, experiencing little drop in secondary market trading volume during that period. In contrast, the non-agency MBS market, where MBS investors are exposed directly to credit risk, proved to be much less stable; Issuance in this market essentially froze in the second half of 2007, and has remained at low levels since that time.4 (1-2, citations and footnotes omitted)

One open question, of course, is whether the risk transfer has been properly priced. We won’t be able to fully answer that question until the next crisis tests these CRT securities. But in the meantime, we can contemplate the authors’ conclusion:

the CRT program represents a valuable step forward towards GSE
reform, as well as a basis for future reform. Many proposals have been put forward for long-term reform of mortgage market since the GSE conservatorships began in 2008. Although the details of these proposals vary, they generally share in common the goals of

(1) ensuring that mortgage credit risk is borne by the private sector (probably with some form of government backstop and/or tail insurance to insure catastrophic risk and stabilize the market during periods of stress), while

(2) maintaining the current securitization infrastructure as well as the standardization and liquidity of agency MBS markets.

The credit risk transfer program, now into its fifth year, represents an effective mechanism for achieving these twin goals. (21, footnote omitted)

Frannie Conservatorships: What A Long, Strange Trip It’s Been

The Federal Housing Finance Agency Office of Inspector General has posted a White Paper, FHFA’s Conservatorships of Fannie Mae and Freddie Mac: A Long and Complicated Journey. This White Paper on conservatorships updates a first one that OIG published in 2012. This one notes that over the past six years,

FHFA has administered two conservatorships of unprecedented scope and simultaneously served as the regulator for these large, complex companies that dominate the secondary mortgage market and the mortgage securitization sector of the U.S. housing finance industry. Congress granted FHFA sweeping conservatorship authority over the Enterprises. For example, as conservator, FHFA can exercise decision-making authority over the Enterprises’ multi-trillion dollar books of business; it can direct the Enterprises to increase the fees they charge to guarantee mortgage-backed securities; it can mandate changes to the Enterprises’ credit underwriting and servicing standards for single-family and multifamily mortgage products; and it can set policy governing the disposition of the Enterprises’ inventory of approximately 121,000 real estate owned properties. (2)

I was particularly interested by the foreward looking statements contained in this White Paper:

Director Watt has repeatedly asserted that conservatorship “cannot and should not be a permanent state” for the Enterprises. Director Watt has indicated that under his stewardship FHFA will continue the conservatorships and build a bridge to a new housing finance system, whenever that system is put into place by Congress. In this phase of the conservatorships, FHFA seeks to place more decision-making in the hands of the Enterprises. (3)

Those who have been hoping that the FHFA will act decisively in the face of Congressional inaction should let that dream go. And given that just about nobody believes (I still hope though) that there will be Congressional reform of Fannie and Freddie during the remainder of the Obama Administration, we must face the reality that we are stuck with the conservatorships and all of the risks that they foster for the foreseeable future. Today’s risks include historically high rates of mortgage delinquencies and exposure to defaults by counterparties like private mortgage insurers. As I have said before, the risks that Fannie and Freddie are nothing to laugh at. Let’s hope that the FHFA is up to managing them until Congress finally acts.