Mortgage Insurers and The Next Housing Crisis

photo by Jeff Turner

The Inspector General of the Federal Housing Finance Agency has released a white paper on Enterprise Counterparties: Mortgage Insurers. The Executive Summary reads,

Fannie Mae and Freddie Mac (the Enterprises) operate under congressional charters to provide liquidity, stability, and affordability to the mortgage market. Those charters, which have been amended from time to time, authorize the Enterprises to purchase residential mortgages and codify an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families. Pursuant to their charters, the Enterprises may purchase single-family residential mortgages with loan-to-value (LTV) ratios above 80%, provided that these mortgages are supported by one of several credit enhancements identified in their charters. A credit enhancement is a method or tool to reduce the risk of extending credit to a borrower; mortgage insurance is one such method. Since 1957, private mortgage insurers have assumed an ever-increasing role in providing credit enhancements and they now insure “the vast majority of loans over 80% LTV purchased by the” Enterprises. In congressional testimony in 2015, Director Watt emphasized that mortgage insurance is critical to the Enterprises’ efforts to provide increased housing access for lower-wealth borrowers through 97% LTV loans.

During the financial crisis, some mortgage insurers faced severe financial difficulties due to the precipitous drop in housing prices and increased defaults that required the insurers to pay more claims. State regulators placed three mortgage insurers into “run-off,” prohibiting them from writing new insurance, but allowing them to continue collecting renewal premiums and processing claims on existing business. Some mortgage insurers rescinded coverage on more loans, canceling the policies and returning the premiums.  Currently, the mortgage insurance industry consists of six private mortgage insurers.

In our 2017 Audit and Evaluation Plan, we identified the four areas that we believe pose the most significant risks to FHFA and the entities it supervises. One of those four areas is counterparty risk – the risk created by persons or entities that provide services to Fannie Mae or Freddie Mac. According to FHFA, mortgage insurers represent the largest counterparty exposure for the Enterprises. The Enterprises acknowledge that, although the financial condition of their mortgage insurer counterparties approved to write new business has improved in recent years, the risk remains that some of them may fail to fully meet their obligations. While recent financial and operational requirements may enhance the resiliency of mortgage insurers, other industry features and emerging trends point to continuing risk.

We undertook this white paper to understand and explain the current and emerging risks associated with private mortgage insurers that insure loan payments on single-family mortgages with LTVs greater than 80% purchased by the Enterprises. (2)

It is a truism that the next crisis won’t look like the last one. It is worth heeding the Inspector General’s warning about the

risks from private mortgage insurance as a credit enhancement, including increasing volume, high concentrations, an inability by the Enterprises to manage concentration risk, mortgage insurers with credit ratings below the Enterprises’ historic requirements and investment grade, the challenges inherent in a monoline business and the cyclic housing market, and remaining unpaid mortgage insurer deferred obligations. (13)

One could easily imagine a taxpayer bailout of Fannie and Freddie driven by the insolvency of the some or all of the six private mortgage insurers that do business with them. Let’s hope that the FHFA addresses that risk now, while the mortgage market is still healthy.

Business as Usual with the CFPB

photo by Lars Plougmann

Law360 quoted me in CFPB Remains Strong Despite DC Circ. Single-Director Ruling (behind paywall). It reads, in part,

A blockbuster D.C. Circuit ruling Tuesday declaring the Consumer Financial Protection Bureau’s single-director leadership structure unconstitutional is unlikely to have a major effect on the bureau’s day-to-day operations and may make it easier for the agency to fend off critics who claim it lacks accountability, experts say.

The 110-page ruling from a split three-judge panel not only decried the leadership structure that Congress gave the CFPB in the 2010 Dodd-Frank Act, but made a change that allows the president to dismiss the bureau’s director at will, in a case that saw a $109 million judgment against PHH Corp. overturned. That move should provide the CFPB with more direct oversight, the D.C. Circuit said.

The change also does not touch the CFPB director’s power to issue rules and enforcement actions and oversee appeals of any administrative actions that the bureau brings. And because of that, the CFPB will not have to change much of what it does despite the harsh words in the opinion, said Frank Hirsch, the head of Alston & Bird’s financial services litigation team.

“I don’t think that the D.C. Circuit opinion was intended to create fundamental differences. I think the fact that the director can be dismissed at will now is the only substantive change,” he said.

Tuesday’s hotly anticipated ruling laid out in stark language many of the concerns that Republicans in Congress, the consumer financial services industry and other critics have long stated about the CFPB’s structure.

PHH was appealing the bureau’s $109 million disgorgement order over allegations the company referred consumers to mortgage insurers in exchange for reinsurance orders with its subsidiaries and reinsurance fees. The conduct, according to the CFPB, violated the Real Estate Settlement Procedures Act.

Included in PHH’s appeal was a constitutional challenge to the CFPB’s structure.

The opinion, written by U.S. Circuit Judge Brett Kavanaugh, laid out the potential dangers of giving one person the amount of authority that is vested in the CFPB director.

Judge Kavanaugh said that the bureau as constructed, with a single director that can only be fired for cause rather than the traditional multimember commission setup at independent regulatory agencies, vested too much power in one person to make decisions about new regulations, enforcement actions and appeals of those enforcement actions in administrative proceedings.

In its way, the CFPB director has authority rivaled only by the president, the decision said.

“Indeed, within his jurisdiction, the director of the CFPB can be considered even more powerful than the president. It is the director’s view of consumer protection law that prevails over all others. In essence, the director is the President of Consumer Finance,” Judge Kavanaugh wrote.

The judge also described at length why commissions were better for independent regulatory agencies than a single director, even though a single director can move more quickly on enforcement actions and rulemakings. Having a commission means that a director or chair will be constrained in their actions, potentially preventing abuses, the opinion said.

“Indeed, so as to avoid falling back into the kind of tyranny that they had declared independence from, the Framers often made trade-offs against efficiency in the interest of enhancing liberty,” Judge Kavanaugh wrote.

Those words were welcomed by the CFPB’s many critics.

“This is a good day for democracy, economic freedom, due process and the Constitution. The second-highest court in the land has vindicated what House Republicans have said all along, that the CFPB’s structure is unconstitutional,” Rep. Jeb Hensarling, the Texas Republican who chairs the House Financial Services Committee, said in a statement.

Hensarling and other Republicans in Congress have long pushed to put a commission atop the CFPB, and legislation Hensarling has introduced to replace Dodd-Frank includes that change.

Backers of the CFPB have long rejected the argument that the bureau is unaccountable, noting that it is subject to notice and comment for rulemaking, its rules are subject to judicial and other reviews, and the director makes regular appearances before Congress.

But instead of installing a commission or eliminating the CFPB altogether because of the constitutional issue, as had been requested by PHH and other, largely conservative activist groups who filed amici briefs, Judge Kavanaugh simply severed the portion of Dodd-Frank that said the bureau’s director could be fired only for cause.

The result is that now the CFPB director is subject to the same employment standard as a cabinet secretary, and can be fired at the president’s whim.

“The president is a check on and accountable for the actions of those executive agencies, and the president now will be a check on and accountable for the actions of the CFPB as well,” Judge Kavanaugh said, adding that all of the CFPB’s previous decisions taken by its current director, Richard Cordray, remained in place.

*     *     *

But even with that uncertainty hanging over the bureau, it is unlikely that the ruling will have much of an effect on the way the CFPB currently operates.

“The industry and consumer advocates can expect to see much of the same,” said David Reiss, a professor at Brooklyn Law School.

Spreading Mortgage Credit Risk

photo by A Syn

The Federal Housing Finance Agency has released the Single-Family Credit Risk Transfer Progress Report. Important aspects of Fannie and Freddie’s future are described in this report. It opens,

Since 2012, the Federal Housing Finance Agency (FHFA) has set as a strategic objective that Fannie Mae and Freddie Mac share credit risk with private investors. While the Enterprises have a longstanding practice of sharing credit risk on certain loans with primary mortgage insurers and other counterparties, the credit risk transfer transactions have taken further steps to share credit risk with private market participants. Since the Enterprises were placed in conservatorship in 2008, they have received financial support from the U.S. Department of the Treasury under the Senior Preferred Stock Purchase Agreements (PSPAs). The Enterprises’ credit risk transfer programs reduce the overall risk to taxpayers under these agreements.

These programs have made significant progress since they were launched in 2012 and credit risk transfer transactions are now a regular part of the Enterprises’ businesses. This progress is reflected in FHFA’s 2016 Scorecard for Fannie Mae, Freddie Mac, and Common Securitization Solutions (2016 Scorecard), which sets the expectation that the Enterprises will transfer risk on 90 percent of targeted single-family, 30-year, fixed-rate mortgages. FHFA works with the Enterprises to ensure that credit risk transfer transactions are conducted in an economically sensible way that effectively transfers risk to private investors.

This Progress Report provides an overview of how the Enterprises share credit risk with the private sector, including through primary mortgage insurance and the Enterprises’ credit risk transfer programs. The discussion includes year-end 2015 data, a discussion of which Enterprise loan acquisitions are targeted for the credit risk transfer programs, and an overview of investor participation information. (1, footnotes omitted)

This push to share credit risk with private investors is a significant departure from the old Fannie/Freddie business model and it should do just what it promises: reduce taxpayer exposure to credit risk for the trillions of dollars of mortgages the two companies guarantee through their mortgage-backed securities. That being said, this is a relatively new initiative and the two companies (and the FHFA, as their conservator and regulator) have to navigate a lot of operational issues to ensure that this transfer of credit risk is priced appropriately.

There are also some important policy issues that have not been settled. The FHFA has asked for feedback on a series of issues in its Single-Family Credit Risk Transfer Request for Input, including,

  • how to “develop a deeper mortgage insurance structure” (RfI, 17)
  • how to develop credit risk transfer strategies that work for small lenders (RfI, 18)
  • how to price the fees that Fannie and Freddie charge to guarantee mortgage-backed securities (RfI, 19)

Congress has abdicated its responsibility to implement housing finance reform, so it is left up to the FHFA to make it happen. Indeed, the FHFA’s timeline has this process being finalized in 2018. The only way for the public to affect the course of reform is through the type of input the FHFA is now seeking:

FHFA invites interested parties to provide written input on the questions listed [within the Request for Input] 60 days of the publication of this document, no later than August 29, 2016. FHFA also invites additional input on the topics discussed in this document that are not directly responsive to these questions.

Input may be submitted electronically using this response form. You may also want to review the FHFA’s update on Implementation of the Single Security and the Common Securitization Platform and its credit risk transfer page as it has links to other relevant documents.