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Keeping Watch on Risk Sharing as the 115th Congress Gets Underway

Treasury Secretary-designate Steve Mnuchin has expressed an interest in resolving the fates of Fannie Mae and Freddie Mac early in the Trump Administration but, until consensus emerges, expect lawmakers to press ahead on their own ideas as aspects of GSE policy, exposing once again complex policy choices.

For example, late last year Reps. Ed Royce (R-CA) and Gwen Moore (D-WI) put a marker down with the “Taxpayer Protections and Market Access for Mortgage Finance Act of 2016, HR 6487.” If introduced in the 115th Congress, the measure would be aimed at addressing several kinds of transactions in housing finance, including Credit Risk Transfer (CRT) transactions or risk sharing. The Royce-Moore bill would have required the FHFA Director to, “establish guidelines requiring that each enterprise engage in significant and increasing credit risk-transfer transactions” within 12 months of the bill’s enactment.

For the last three years, FHFA has required Fannie and Freddie to share credit risk on securitized mortgages, or at the back-end.  In 2016, plans were announced to introduce risk sharing at the front-end, or when mortgages are originated.  Commenting on the Royce-Moore bill late last year, Compass Point Research and Trading’s Isaac Boltansky concluded it was “generally more supportive of front-end execution.” If Congress and the Trump Administration embraced this idea it could mean faster sailing into uncharted waters.

Former Fannie Mae CFO Tim Howard explained the many uncertainties of risk sharing during an Investors Unite teleconference last fall. Noting that the GSEs are making money and are highly profitable and yet cannot retain earnings due to the Net Worth Sweep, Howard said there are serious flaws in the underpinnings of risk sharing foisted upon the GSEs by Treasury and FHFA.  Without the “normal economic discipline” that would apply if the companies were not in conservatorship, he said Fannie and Freddie’s risk-sharing decisions are not good for borrowers or taxpayers.

Under these mandatory risk sharing policies, it appears FHFA and Treasury assume the guaranty fees, or g-fees, Fannie and Freddie are charging will be there to cover costs. Therefore, the theory goes, any credit risk sharing underway is better than leaving the risk with the GSEs, which have been depleted of their capital. Absent the normal business rationale, Howard said there are at least four problems with this. First, borrowers are hurt by having to pay an arbitrarily high g-fee. Second, there is no transparent way to compare the relative efficiency of the different types of risk sharing being considered. Third, it doesn’t explicitly take into account risk sharing costs borne by the borrower, such as deep-cover mortgage insurance or MI. And perhaps most importantly, it is far from clear whether it is actually achieving the desired result of transferring risk to the private market in a significant way.

If Fannie and Freddie had been able to retain their capital, consistent with the requirements of the Housing and Economic Recovery Act, it would at least be possible to use their cost of equity capital as the basis for assessing all risk sharing alternatives. This is what the companies did before being placed into conservatorship. If the cost of backing credit risk with shareholders’ equity was known, then assessing risk sharing alternatives would be straightforward. Howard would apply what he calls a “borrower benefit” standard.

Looking at the three main types of risk sharing, he concluded that, without a solid grasp of Fannie and Freddie’s real cost of capital, the impact on borrowers of two risk sharing strategies, “deep-cover” mortgage insurance on the front end and mortgage reinsurance transactions on the back end, is really just a matter of “guess work.”  The third, securitized credit-risk transfers, is easier to evaluate but it makes little economic sense. Using the prospectuses for both Fannie’s Connecticut Avenue Securities (or CAS) risk-sharing program and Freddie’s Structured Agency Credit Risk (or STACR) program, he ran the numbers and concluded the following: “Fannie’s CAS issues are a complete waste of money.”

More importantly, FHFA and Treasury tout such risk-sharing mechanisms as the future of mortgage securitization but the government is peddling securities whose face value is less than what it would seem. “Saying you’ve transferred credit risk when you actually haven’t is a prescription for disaster,” Howard said. He compared it to the collateralized debt obligations that led to the housing bubble from ten years ago and commented, “We know how that turned out.”

After Howard finished his analysis, Investors Unite Executive Director Tim Pagliara concluded that Howard had essentially accused FHFA and Treasury of engaging in “mortgage financing malpractice” because they were “giving away the store.” Risk sharing is not in the interest of borrowers, American taxpayers or the rehabilitation of the companies so they can be released from the conservatorship, as the law requires, Pagliara said.

Howard agreed that trying to build a future housing finance system on securitized risk transfers that cannot be justified as sound or effective is a mistake. He said draining assets from the companies in this way is bound to “blow up” and concluded, “So, yes, I am happy to be outspoken because I think it would be a mammoth public policy mistake to go forward with something we know won’t work.”

Such admonitions could and should slow momentum for any GSE “reform” ideas that are not good for taxpayers, home buyers and shareholders.